Chapter 2

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Chapter 2A Further Look at Financial Statements

Explain the meaning of generally accepted accounting principles and describe the basic objective of financial reporting.

Discuss the qualitative characteristics of accounting information.

Identify two constraints in accounting.Identify the sections of a classified balance

sheet.

After studying Chapter 2, you should be able to:

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Identify and compute ratios for analyzing a company's profitability.

Explain the relationship between a retained earnings statement and a statement of stockholders' equity.

Identify and compute ratios for analyzing a company's liquidity and solvency using a balance sheet.

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

Chapter 2A Further Look at Financial Statements

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General Guide for Financial Accounting

GenerallyAcceptedAccountingPrinciples

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What is financial accounting supposed to accomplish?Provide the the most useful financial information for…

Decision Making

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Primary Accounting Setting Body in the U.S.

FinancialAccountingStandardsBoard

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U.S. Government Agency That Oversees Financial Markets

SecuritiesExchangeCommission

Remember…

GAAP Are the Rules

The FASB makes the rules.

The SEC enforces the rules.

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Basic Terms Relevance - information makes a difference

in decisions Reliability - information must be free of

error and bias Comparability - ability to compare

information of different companies because they use the same accounting principles

Consistency - use of same accounting principles and methods from year to year within the same company

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Characteristics of Useful Information

Relevance

1. Provides a basis for forecasts

2.Confirms/corrects prior expectations

3. Is timely

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Reliability

1. Is verifiable

2. Is a faithful representation

3. Is neutral

Comparability

Different companies use similar accounting PRINCIPLES

Consistency

Company uses same accounting METHODS from year to year

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Constraints in Accounting

Permits companies to apply GAAP without hurting the usefulness of information

Materiality - The constraint of determining whether an item is large enough to likely influence a decision.

Conservatism - The approach of choosing an accounting method, when in doubt, that will be least likely to overstate assets and net income.

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A 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

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Current AssetsAssets that are expected to be converted to cash or used in

the business within one year. Current assets are listed in order of liquidity.Examples:

Cash Short-term investments Receivables Inventories Supplies Prepaid expenses

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Long-Term InvestmentsAssets 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 of stocks and bonds of

other corporations. Investments in long-term assets

such as land or buildings that are not currently being used in the company’s operating activities.

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Property, Plant, and EquipmentAssets with relatively long

useful lives.Assets used in operating

the business.Examples:

land buildings machinery delivery equipment furniture and fixtures

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Depreciation is...

Practice of allocating an asset’s full purchase price to a number of years instead of expensing full cost in year of purchase.

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Accumulated Depreciation...

Shows the total amount of depreciation taken over the life of the asset.

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Assets That A Company Depreciates...

Should be shown at cost less accumulated depreciation

CSU CORPORATION Balance Sheet

December 31, 2004

AssetsCash $ 2,000Accounts receivable 4,000Supplies 1,800Equipment 24,000 Less: Accumulated Depreciation 8,000 16,000Total assets $23,800

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Intangible Assets have valuebecause of the exclusive

rights or privileges they possess.

Intangible AssetsNoncurrent assetsHave no physical substanceExamples:

patents copyrights trademarks or trade names franchise

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Current LiabilitiesObligations that are supposed to be

paid within the coming year...accounts payablewages payablebank loans payableinterest payabletaxes payablecurrent maturities of

long-term bankloans payable

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Long-Term Liabilities

Debts expected to be paid after one yearExamples… bonds payable mortgages payable long-term notes payable lease liabilities and obligations under employee pension plans

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Stockholders' Equity

Capital stock - investments in the business by the stockholders

Retained earnings - earnings kept for use in the business

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HUMANA CORPORATIONBalance Sheet

December 31, 200X

(in millions)AssetsCurrent Assets

Cash $ 272Marketable securities (current) 609Receivables 74Other current assets 83

Total current assets 1,038Property and equipment (net) 317

Marketable securities (long-term) 322 Other long-term assets 280Total Assets $1,957 Liabilities and Stockholders’ Equity Liabilities

Current LiabilitiesMedical costs payable $ 527

Accounts payable 233Income taxes payable 56

Total current liabilities 816Long-term debt 83

Total liabilities 899Stockholders’ equity

Common stock 830Retained earnings 228

Total Liabilities and stockholders’ equity $1,957

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Ratio Analysis...Expresses relationship among

selected items of financial statement data

Relationship can be expressed in term of…percentagerateproportion

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Ratio Analysis Classifications...Liquidity Ratios - measures of short-

term ability of the company to pay its maturing obligations and to meet unexpected needs for cash

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

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

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Ratio Analysis 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

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Profitability Ratios...

Measures of the income or operating success of a company for a given

period of time Two Examples… Earnings Per Share Price-Earnings Ratio

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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=

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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

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Statement of Retained Earnings

Describes the events that caused changes in the retained earnings account for the period.

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CSU CORPORATIONRetained Earnings Statement

For the Year Ended December 31, 200X

Retained earnings, January 1 $ 0Add: Net Income 6,800 6,800Less: Dividends 0Retained earnings, December 31 $ 6,800

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Statement of Retained Earnings and Statement of Stockholders

Equity

Stockholders’ Equity:Retained EarningCommon StockSince both of these parts affect

stockholders’ equity…a statement of stockholders’ equity

provides better information than a statement of retained earnings.

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Financial Ratio ClassificationsLiquidity Ratios - measures of short-term

ability of the company to pay its maturing obligations and to meet unexpected needs for cash

Profitability Ratios -measures of the income or operating success of a company for a given period of time

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

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Liquidity Ratios

Working capital

Current ratio

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Working Capital

Measures short-term ability

to pay liabilities

Current Assets - Current Liabilities = Working Capital

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Current Ratio

Measure of short - term ability to pay obligations

Current Ratio =Current AssetsCurrent Liabilities

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Solvency Ratio

Debt to Total Assets Ratio measures % of assets financed by creditors.

Total DebtsTotal Assets

Debt to Total Asset Ratio =

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Purpose of Statement Of Cash Flows

To provide information about cash receiptscash paymentsnet changes in cash

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Changes Result From

Operating activitiesFinancing activitiesInvesting activities

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Operating Activities

Cash inflows and cash outflows associated with the primary operations of the business.

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Financing Activities

Cash inflows/ outflows come from sources funding the business…

Sale of Stock/ Payment of Dividends

Issuing Debt/Repaying Debt

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Investing Activities

Cash inflows/ outflows result from changes in investments and long-term assets…

purchasing/disposing of investments and long-lived assets using cash

lending money and collecting the loans