Same accounting principles and methods used from year to year within a company

A Further Look at Financial Statements

Study Ob jectives

• Identify the sections of a classified balance sheet.
• 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.
• Use the statement of cash flows to evaluate solvency.
• Explain the meaning of generally accepted accounting principles.
• Discuss financial reporting concepts.

Chapter Outline

Study Ob jective 1 - Identify the Sections of a Classified Balance Sheet

In a classified balance sheet companies often group similar assets and similar liabilities together as they have similar economic characteristics. The groupings help users to determine (1) whether the company has enough assets to pay its debts and (2) the claims of short-and long-term creditors on the company's total assets.

A classified balance sheet generally contains the following standard classifications:

Current Assets

• Assets that are expected to be converted to cash or used in the business within a short period of time, usually one year
• Examples of current assets: cash, short-term investments (which include marketable securities), receivables (accounts receivable and notes receivable), inventories, supplies, and prepaid expenses (rent, insurance, advertising).
• On the balance sheet, current assets are listed in the order in which they are expected to be converted into cash (order of liquidity).

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.
• Examples are investments of stocks and bonds of other corporations.

 Property, Plant, and Equipment

• Assets with relatively long useful lives.
• Assets used in operating the business.
• Examples include land, buildings, machinery, delivery equipment, and furniture and fixtures.
• These are listed in the order of permanency.
• Record these assets at cost and depreciate them (except land) over their useful lives. The full purchase price is not expensed in the year of purchase because the assets will be used for more than one accounting period.
• Depreciation is the practice of allocating the cost of assets to a number of years.
• Depreciation expense is the amount of the allocation for one accounting period. Accumulated depreciation is the total amount of depreciation that has been expensed since the asset was placed in service.
• Cost less accumulated depreciation is reported on the balance sheet.
• Depreciation is not a valuation of assets. It is the allocation of their cost over the periods in which they will benefit the business.

Intangible Assets

• Noncurrent assets.
• Assets that have no physical substance.
• Examples are patents, copyrights, and trademarks or trade names.

Current Liabilities

• Obligations that are to be paid within the coming year
• Common examples are notes payable, accounts payable, wages payable, bank loans payable, interest payable, taxes payable, and current maturities of long-term bank loans payable, interest payable, and current maturities of long-term obligations.

 Long-Term Liabilities

• Obligations expected to be paid after one year.
• Liabilities in this category include bonds payable, mortgage payable, long-term notes payable, lease liabilities, and obligations under employee pension plans.

Stockholders' Equity

• Common Stock - investments of assets into the business by the stockholders.
• Retained earnings - income retained for use in the business.

Study Ob jective 2 -Identify and Compute Ratios for Analyzing a Company's Profitability

Ratio analysis expresses the relationship among selected items of financial statement data.

• A ratio expresses the mathematical relationship between one quantity and another.

• The relationship is expressed in terms of

  • Percentage – 127%
  • Rate – 1.27 times
  • Proportion: 1:27 to 1
  • Ratios shed light on company performance
    • Intracompany comparisons – two years for the same company
    • Industry-average comparisons – average ratios for particular industries
    • Intercompany comparisons – comparisons with a competitor in the same industry
  Creditors and investors are interested in evaluating profitability. Profitability is frequently used as a test of management's effectiveness. To supplement an evaluation of the income statement, ratio analysis is used.

Profitability ratios - measure the income or operating success of a company for a given period of time.

Earnings per share

is a profitability ratio that measures the net income earned on each share of common stock.

is computed by dividing net income by the average number of common shares outstanding during the year.

By comparing earnings per share of a single company over time, one can evaluate its relative earnings performance on a per share basis.

Comparisons of earnings per share across companies are not meaningful because of the wide variations in numbers of shares of outstanding stock among companies.

Study Ob jective 3 - Explain the Relationship Between a Retained Earnings

Statement and a Statement of Stockholders' Equity

Retained Earnings Statement

• Describes the events that caused changes in the retained earnings account for the period.
• Add net income to and subtract dividends from beginning balance of retained earnings to arrive at ending balance of retained earnings.

Statement of Stockholders' Equity

• Reports all changes in stockholders' equity accounts (i.e. capital stock issued or retired).

Study Ob jective 4 - Identify and Compute Ratios for Analyzing a Company's Liquidity and Solvency Using a Balance Sheet

An analysis of the relationship between a company's assets and liabilities can provide users with information about the firm's liquidity and solvency.

Liquidity - The ability to pay obligations expected to come due within the next year or operating cycle. There are two measures of liquidity.

• Working capital
  • Measure of short-term ability to pay obligations
  • Excess of current assets over current liabilities
  • Positive working capital indicates the likelihood for paying liabilities is favorable.
  • Negative working capital indicates that a company might not be able to pay short-term creditors and may be forced into bankruptcy.
• Current ratio
  • Measure of short-term ability to pay obligations
  • Computed by dividing current assets by current liabilities
  • More dependable indicator of liquidity than working capital
  • Does not take into account composition of current assets
  A 1.6:1 ratio means that for every $1 in debt, the company has $1.6 in current assets to pay the debt.

Solvency - The ability of a company to pay interest as it comes due and to repay the face value of debt at maturity.

Debt to Total Assets Ratio

• Measures the percentage of assets financed by creditors
• The higher the percentage of debt financing, the riskier the business.
• Computed by dividing total debt (both current and long-term liabilities) by total assets

Study Ob jective 5 – Use the Statement of Cash Flows to Evaluate Solvency

The statement of cash flows provides financial information about the sources and uses of a company's cash. To aid in the analysis of cash, the statement of cash flows reports the cash effect of company's:

Financing activities - Cash inflows from sources funding the business (i. e. sale of stock, sale of bonds, borrowings, etc.). Cash outflows for repaying debt, paying dividends, or buying shares of the company’s stock.

Investing activities - Cash outflows from purchasing resources needed in operating the business. Cash inflows from selling these resources.

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

• Companies get cash from two sources: operating activities and financing activities.
• In the early years of a company’s life it typically will not generate enough cash from operating activities to meet its investing needs.
• Thus, it will issue stock or borrow money.
• An established company should be able to meet most of its cash needs from operating activities.
• Cash is needed to purchase property, plant, and equipment throughout the life of the company.

Free cash flow is a measurement that provides insight regarding a company’s cash-generating ability.

• It describes the cash remaining from operations after ad justing for capital expenditures and dividends.
• It is computed by subtracting capital expenditures and cash dividends from cash provided by operations.

Study Ob jective 6 - Explain the Meaning of Generally Accepted Accounting Principles

Generally Accepted Accounting Principles (GAAP) are accounting guidelines that provide answers to the following questions.

• How does a company decide on the amount and type of financial information to disclose?
• What format should a company use?
• How should a company measure assets, liabilities, revenues, and expenses?

The primary accounting standard-setting body in the U. S. is the Financial Accounting Standards Board (FASB).

The International Accounting Standards Board (IASB) sets standards for many countries outside the U.S.

The FASB and IASB are working closely to minimize the differences in accounting standards among various countries.

The Securities and Exchange Commission (SEC) is a U.S. government agency that oversees U.S. financial markets and accounting standard-setting agencies.

Study Ob jective 7 – Discuss Financial Reporting Concepts

To be useful, financial information should possess the following characteristics: relevance, reliability, comparability, and consistency.

Relevance - if information has the ability to make a difference in a decision scenario, it is relevant.

Accounting information is also relevant to business decisions because it provides a basis for forecasting future earnings and confirms or corrects prior expectations. Financial statements help predict future events and provide feedback about prior expectations about the financial health of the company. In order to be relevant accounting information must be timely.

When you were trying to decide what to wear to class, did it matter whether you were going to an English class or an Accounting class? No. That information was not relevant.

On the other hand, when you were making the decision, the outside temperature did make a difference. Therefore the temperature was a relevant factor.

 Reliability - information is reliable if it can be depended on. To be reliable information must be:

• verifiable--free from error and bias,
• faithful representation--factual, and
• neutral --cannot be selected, prepared, or presented to favor one set of users over another.

Comparability and Consistency

• comparability--when different firms use the same accounting principles
• Companies must disclose the accounting methods used.
• consistency--when firms use the same accounting principles and methods from year to year

Consistency requires firms to be consistent in the accounting principles used. However, if there is justification for changing from one principle to another, it must be explained in the Notes to the Financial Statements. The explanation lets users know what has happened to make the difference.

To develop accounting standards, the FASB relies on the following key assumptions and principles:

Monetary unit assumption

• States that only transactions expressed in terms of money are included in accounting records.

Economic entity assumption

• Every economic entity can be separately identified and accounted for.
• Requires economic activities of an entity be kept separate from those of owner and separate from all other economic entities.

Time period assumption - allows the business to be divided into artificial time periods.

Going concern assumption

• Assumes business will be in existence for the foreseeable future
• Assumption allows use of cost (rather than liquidation value)

Cost principle - requires assets to be recorded at original cost because that amount is verifiable.

Full disclosure principle – requires that all circumstances and events that would make a difference to financial statement users should be disclosed.

Constraints allow a company to modify generally accepted accounting principles without reducing the usefulness of the information content. This ensures that companies apply accounting rules in a reasonable fashion. These constraints are:

 Materiality - an item is material when its size makes it likely to influence the decision of an investor or a creditor. An item is immaterial if it is too small to impact on the decision.

• The company does not have to follow GAAP for immaterial items.

Materiality allows firms to modify GAAP. Assume a firm buys a new electric pencil sharpener that is expected to last for 6 years for $18.GAAP say that the pencil sharpener, because it is expected to last for 6 years, should be listed as an asset and depreciated--or charged off--over 6 years at a rate of $3 per year. The materiality constraint allows the firm to expense the pencil sharpener immediately because the $18 expense will not make a difference to the users of financial statements.

Conservatism - allows the accountant to choose the accounting method that will be the least likely to overstate assets and income. Many times items in inventory become obsolete or damaged. In this instance inventory items should be listed at market value if it is lower than cost.

• A company should not intentionally understate assets or income.

Is an accounting principle which states that accounting methods used should be the same from year to year?

What ensures that accountants use the same principles and methods of recording from year to year within a company?

What is it called when different companies use the same accounting principles?

Why is it important for a company to maintain the same accounting methods and practices from period to period?