1. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. A Further Look at Financial Statements Chapter 2 Prepared by Carol A. Hartley Providence College Principles of Accounting Kimmel Weygandt Kieso

2. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Study Objectives 1.Explain the meaning of generally accepted accounting principles and describe the basic objective of financial reporting. 2.Discuss the qualitative characteristics of accounting information. 3.Identify two constraints in accounting. 4.Identify the sections of a classified balance sheet.

3. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Study Objectives 5.Identify and compute ratios for analyzing a company’s profitability. 6.Explain the relationship between a retained earnings statement and a statement of stockholders’ equity. 7.Identify and compute ratios for analyzing a company’s liquidity and solvency using a balance sheet. 8.Identify and compute ratios for analyzing a company’s liquidity and solvency using a statement of cash flows.

4. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. # 1 Generally Accepted Accounting Principles GAAPGAAP Agreed-upon accounting rulesAgreed-upon accounting rules Most U.S. companies useMost U.S. companies use Promulgated by Financial Accounting Standards Board - FASBPromulgated by Financial Accounting Standards Board - FASB

5. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. # 1 Basic Objective of Financial Reporting Provide information useful for decision making

6. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Recall Content and Purpose of Financial Statements Recall Content and Purpose of Financial Statements Income StatementIncome Statement Retained Earnings StatementRetained Earnings Statement Balance SheetBalance Sheet Statement of Cash FlowsStatement of Cash Flows

7. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Recall Users of Financial Statements Recall Users of Financial Statements Internal UsersInternal Users External UsersExternal Users

8. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. # 2 Qualitative Characteristics of Accounting Information RelevanceRelevance ReliabilityReliability ComparabilityComparability ConsistencyConsistency

9. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Relevance Makes a difference to the decisionMakes a difference to the decision Confirms or corrects prior expectations, feedback valueConfirms or corrects prior expectations, feedback value Helps predict future eventsHelps predict future events It is timelyIt is timely

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

11. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Comparability & Consistency Comparability – different companies use similar accounting policiesComparability – different companies use similar accounting policies Comparability – a firm uses similar accounting policies year to yearComparability – a firm uses similar accounting policies year to year

12. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. # 3 Constraints in Accounting MaterialityMateriality ConservatismConservatism

13. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Materiality Will it influence the decision?Will it influence the decision? –MATERIAL No impact on decision?No impact on decision? –IMMATERIAL © PhotoDisc/Getty Images

14. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Conservatism When in doubt, choose method least likely to overstate assets and income Do not intentionally understate!

15. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review What organization issues United States accounting standards? a. Financial Accounting Standards Board. d. None of the above. c. Internal Auditing Standards Committee. b. Internal Accounting Standards Committee.

16. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review What organization issues United States accounting standards? a. Financial Accounting Standards Board d. None of the above. c. Internal Auditing Standards Committee b. Internal Accounting Standards Committee.

17. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review What is the primary criterion by which accounting information can be judged? a. Consistency. d. Comparability. c. Usefulness for decision making. b. Predictive value.

18. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review What is the primary criterion by which accounting information can be judged? a. Consistency. d. Comparability. c. Usefulness for decision making. b. Predictive value.

19. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review What accounting constraint refers to the tendency of accountants to resolve uncertainty in a way least likely to overstate assets and revenues? a. Comparability. d. Consistency. c. Conservatism. b. Materiality.

20. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review a. Comparability. d. Consistency. c. Conservatism b. Materiality. What accounting constraint refers to the tendency of accountants to resolve uncertainty in a way least likely to overstate assets and revenues?

21. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. # 4 Identify the Sections of a Classified Balance Sheet Helps users see if company has enough assets to pay debtsHelps users see if company has enough assets to pay debts Can determine the short-term and long-term claims on total assetsCan determine the short-term and long-term claims on total assets

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

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

24. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Current Assets Examples: –Cash –Short-term investments –Receivables –Inventories –Supplies –Prepaid expenses

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

26. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Long-Term Investments Example: –Investments of stocks and bonds of other corporations.

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

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

29. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Property, Plant, and Equipment - Depreciation

30. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Intangible Assets Non-current assets No physical substance

31. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Current Liabilities Obligations that are supposed to be paid within the coming year...

32. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Current Liabilities accounts payable wages payable bank loans payable interest payable taxes payable current maturities of long-term loans payable

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

34. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Stockholders' Equity Capital (Common) stock - investments in the business by the stockholders Retained earnings – net income retained for use in the business

35. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Put It All Together...

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

38. Let’s Review How are current assets listed on the balance sheet? a. by liquidity. d. alphabetically. c. by longevity. b. by importance.

39. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review How are current assets listed on the balance sheet? a. by liquidity. d. alphabetically. c. by longevity. b. by importance.

40. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Many companies have valuable long-term assets that cannot be seen. These assets are referred to as? a. Fixed assets. d. Notes payable. c. Intangible assets. b. Accounts receivable.

41. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Many companies have valuable long-term assets that cannot be seen. These assets are referred to as? a. Fixed assets. d. Notes payable. c. Intangible assets. b. Accounts receivable.

42. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s extend the discussion and learn about some tools to analyze financial statements...

43. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Ratio Analysis Expresses relationship among selected items of financial statement data Relationship can be expressed in terms of… –Percentage –Rate –Proportion

44. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Ratio Analysis - Classifications Liquidity RatiosLiquidity Ratios - measure short-term ability of company to pay maturing obligations and meet unexpected needs for cash

45. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Ratio Analysis - Classifications Profitability RatiosProfitability Ratios - Measures of the income or operating success of a company for a given period of time

46. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Ratio Analysis - Classifications Solvency RatiosSolvency Ratios - Measures of the ability of the company to survive over a long period of time

47. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Ratio Analysis – 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

48. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. # 5 Identify and Compute Ratios for Analyzing a Company’s Profitability

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

50. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Earnings Per Share How does the company’s earning performance compare with that of previous years? Higher value = improved performance Net income-Preferred stock dividends Average common shares outstanding EPS=

51. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 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 = Stock price per share Earnings per share

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

53. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. # 6 Explain the Relationship Between a Retained Earnings Statement and a Statement of Stockholders’ Equity

54. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Statement of Retained Earnings Recall from Chapter 1: The Statement of Retained Earnings Recall from Chapter 1: The Statement of Retained Earnings describes the changes in the retained earnings for the period...

55. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Recall from Chapter 1 - Statement of Retained Earnings CSU Corporation Retained Earnings Statement For the Year Ended December 31, 2005 Retained earnings, January 1$ 0 Add: Net income 6,800 6,800 6,800 Less: Dividends 600 Retained earnings, Dec. 31 $ 6,800

56. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Statement of Stockholders’ Equity Recall earlier we said that stockholders’ equity has two parts: Common Stock and Retained Earnings, Thus, The Statement of Stockholders’ Equity reports ALL CHANGES in all of the stock accounts and retained earnings...

57. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Statement of Stockholders’ Equity

58. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Which is not an indicator of profitability? a. Current ratio. d. Price-earnings ratio. c. Net income. b. Earnings per share.

59. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Which is not an indicator of profitability? a. Current ratio. d. Price-earnings ratio. c. Net income. b. Earnings per share.

60. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review For 2005 Stoneland Corporation reported net income $24,000; net sales $400,000; and average shares outstanding 6,000. There were no preferred stock dividends. What was 2005 earnings per share? a. $4.00 d. $66.67 c. $16.67 b. $0.06

61. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review For 2005 Stoneland Corporation reported net income $24,000; net sales $400,000; and average shares outstanding 6,000. There were no preferred stock dividends. What was 2005 earnings per share? a. $4.00 d. $66.67 c. $16.67 b. $0.06

62. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review The balance in retained earnings is not affected by: a. Net income. d. Dividends. c. Issuance of common stock. b. Net loss.

63. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review The balance in retained earnings is not affected by: a. Net income. d. Dividends. c. Issuance of common stock. b. Net loss.

64. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. # 7 Identify and Compute Ratios for Analyzing a Company’s Liquidity and Solvency Using a Balance Sheet

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

66. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Working Capital 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!

67. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Current Ratio Current Ratio = Current Assets Current 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 assetsDoes not consider composition of current assets

68. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Current Ratio Industry average means?

69. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Current Ratio Industry means? Industry average means? $1.49 of current assets for every $1 of current debt

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

71. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Debt to Total Assets Ratio Divide total debt (current and long-term liabilities) by total assets Total Debts Total Assets Debt to Total Asset Ratio = Measures percentage of assets financed by creditors rather than stockholdersMeasures percentage of assets financed by creditors rather than stockholders

72. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Selected financial information for Drummond Company at 12/31/2005: Let’s compute current ratio...

73. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review – Compute Current Ratio $210,000 $140,000 = 1.5 : 1 

74. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Selected financial information for Drummond Company at 12/31/2005: Now, let’s compute debt to total assets...

75. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review – Compute Debt to Total Assets $270,000  $540,000 = 50%

76. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. # 8 Identify and Compute Ratios for Analyzing a Company’s Liquidity and Solvency Using a Statement of Cash Flows

77. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Recall from Chapter 1 - Statement of Cash Flows Provides information about sources and uses of cash, organized as... Operating Activities Investing Activities Financing Activities

78. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Statement of Cash Flows

79. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Current Cash Debt Coverage Ratio Cash Provided by Operating Activities Average Current Liabilities Another measure of liquidity Another measure of liquidity Indicates ability to generate cash to meet short-term needsIndicates ability to generate cash to meet short-term needs

80. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Cash Debt Coverage Ratio Cash Provided by Operating Activities Average Total Liabilities Another measure of solvency Another measure of solvency Indicates ability to generate cash to meet long-term needsIndicates ability to generate cash to meet long-term needs

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