Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso, Trenholm KIMMEL Prepared by: Barbara Trenholm University of New Brunswick

Chapter 2 A Further Look at Financial Statements After studying Chapter 2, you should be able to: Describe the basic objective of financial reporting, and explain the meaning of generally accepted accounting principles. Discuss the qualitative characteristics of accounting information. Identify two constraints in accounting. Identify the sections of a classified balance sheet. 1

Chapter 2 A Further Look at Financial Statements After studying Chapter 2, you should be able to: Identify and compute ratios for analysing a company's profitability. Explain the relationship between a statement of retained earnings, a statement of earnings, and a balance sheet. Identify and compute ratios for analysing a company's liquidity and solvency. 2

Objective of Financial Reporting Provide the most useful financial information for decision making 4

General Guide for Financial Reporting Generally Accepted Accounting Principles

Characteristics of Useful Information Understandability Relevance Reliability Comparability and consistency

Characteristics of Useful Information Illustration 2-1 Characteristics of Useful Information

Constraints in Accounting Modify GAAP without hurting the usefulness of information Cost-benefit Materiality 10

Classified Balance Sheet Generally contains the following standard classifications: Assets Current assets Long-term investments Capital assets Liabilities Current liabilities Long-term liabilities Shareholders’ Equity Share capital Retained earnings 21

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 Receivables Inventories Prepaid expenses 22

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 23

Capital Assets Assets with relatively long useful lives Assets used in operating the business Two categories of capital assets Tangible (with physical substance) Intangible (with no physical substance)

Tangible Capital Assets Examples Property, plant, and equipment Land Buildings Machinery and equipment Furniture and fixtures Natural resources Mineral deposits Timber 24

Intangible Capital Assets Examples Patents Copyrights Trademarks or trade names Franchise Intangible assets have value because of the exclusive rights or privileges they possess

Amortization Allocation of an asset’s full purchase price to match cost to revenues over entire estimated useful life instead of expensing full cost in year of purchase Amortization is allocated for all capital assets except land 24

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 8

CSU CORPORATION Balance Sheet December 31, 2001 Capital assets should be shown at net book value (cost less accumulated amortization) Assets Cash $ 2,000 Accounts receivable 4,000 Supplies 1,800 Equipment 24,000 Less: Accumulated amortization 8,000 16,000 Total assets $23,800 24

Current Liabilities Obligations that are supposed to be paid within the coming year Accounts payable Wages payable Notes (bank loans) payable Interest payable 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 27

Shareholders' Equity Share capital Retained earnings Investments in the business by the shareholders Retained earnings Earnings kept for use in the business 28

Current Current Assets Current assets Cash $ 272 ANY CORPORATION Balance Sheet (Sample Presentation) December 31, 2001 (in millions) Assets Current assets Cash $ 272 Short-term investments (current) 609 Receivables 74 Other current assets 83 Total current assets 1,038 Investments (long-term) 317 Capital assets 322 Other long-term assets 280 Total assets $ 1,957 Liabilities and Shareholders’ Equity Liabilities Current liabilities Notes payable $ 527 Accounts payable 233 Income taxes payable 56 Total current liabilities 816 Long-term debt 83 Total liabilities 899 Shareholders’ equity Share capital 830 Retained earnings 228 Total shareholders’ equity 1,058 Total liabilities and shareholders’ equity $ 1,957 Current Current

Ratio Analysis Mathematical relationship Relationship can be expressed in terms of Percentage Rate Proportion

Comparisons Intracompany (prior years of your company) Intercompany (between companies) Industry averages

Financial Ratio Classifications Profitability ratios Measures of the earnings or operating success of a company for a given period of time Liquidity ratios Measures of short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash Solvency ratios Measures of the ability of a company to survive over a long period of time

Using the Statement of Earnings With profitability ratios Return on assets Profit margin

Profitability Return On Assets Ratio Reveals the amount of net earnings generated by each dollar invested Return on assets = Net earnings Average total assets Higher value suggests favourable efficiency 18

Profitability Profit Margin Ratio Measures the percentage of each dollar of sales that results in net earnings Profit margin = Net earnings Net sales Higher value suggests favourable return on each dollar of sales 19

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 + - 20

CSU CORPORATION Statement of Retained Earnings For the Year Ended December 31, 2001 Retained earnings, January 1 $ 0 (1) Add: Net earnings 6,800 (2) 6,800 Less: Dividends 0 Retained earnings, December 31 $ 6,800 (3) Statement interrelationships: Opening retained earnings comes from, and agrees to, ending retained earnings on prior period balance sheet Net earnings comes from, and agrees to, net earnings on statement of earnings Ending retained earnings goes to, and agrees to, ending retained earnings on current period balance sheet

Using the Balance Sheet With liquidity ratios Working capital Current ratio With solvency ratios Debt to total assets

Liquidity Working Capital Measures short-term ability to pay liabilities Current assets - current liabilities = Working capital 31

Liquidity Current Ratio Measure of short term ability to pay obligations Current ratio = Current assets Current liabilities 32

Solvency Debt to Total Assets Measures % of assets financed by creditors Debt to total assets = Total liabilities Total assets 33

Using the Statement of Cash Flows To provide information about Cash receipts Cash payments Changes in cash (and cash equivalents) From changes in Operating activities Financing activities Investing activities 35

Operating Activities Cash inflows and cash outflows associated with the primary operations of the business 38

Financing Activities Cash inflows / outflows come from sources funding the business Sale of shares / payment of dividends Issuing debt / repaying debt 36

Investing Activities Cash inflows/ outflows result from changes in investments and capital assets Purchasing/disposing of investments and long-lived assets using cash Lending money and collecting the loans 37

Liquidity Cash Current Debt Coverage Measures ability to generate sufficient cash to satisfy short-term needs Cash current debt coverage ratio = Cash provided by operating activities Average current liabilities 33

Solvency Cash Total Debt Coverage Measures ability to generate sufficient cash to meet long-term needs Cash total debt coverage ratio = Cash provided by operating activities Average total liabilities

Decision Checkpoints Return on assets ratio Is the company using its assets effectively? Is the company maintaining an adequate margin between sales and expenses? Can the company meet its short-term obligations? Can the company meet its long-term obligations? Return on assets ratio Profit margin ratio Working capital, current ratio, cash current debt coverage ratio Debt to total assets ratio, cash total debt coverage ratio

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