©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones9 - 1 Chapter 9 The Balance Sheet and Income Statement – A Closer Look

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones9 - 2 Learning Objective 1 Describe how the balance sheet and income statement were developed as financial statements.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones9 - 3 Development of the Balance Sheet and Income Statement The balance sheet’s function as a financial statement only emerged during the Renaissance, around A.D Accountants developed the income statement in the late 1800s. By the 1930s, it became apparent that the balance sheet and the income statement are best used together.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones9 - 4 The Balance Sheet Eliason and Company Balance Sheet December 31, 2004 Total assets$1,566,800 Liabilities$ 901,000 Stockholders’ equity 665,800 Total liabilities and stockholders’ equity$1,566,800

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones9 - 5 Learning Objective 2 Explain the organization and purpose of the classified balance sheet.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones9 - 6 The Classified Balance Sheet Eliason and Company Balance Sheet December 31, 2004Assets: Current assets: Cash$ 100 Cash$ 100 Accounts receivable 251,000 Accounts receivable 251,000 Inventory 298,900 Inventory 298,900 Prepaid expenses 50,000 Prepaid expenses 50,000 Total current assets$ 600,000 Long-term investments 34,000 Property, plant, and equipment: Land$125,000 Land$125,000 Plant and equipment$1,075,000 Plant and equipment$1,075,000 Less: Acc. depreciation– 283,200 Less: Acc. depreciation– 283,200 Plant and equipment, net 791,800 Plant and equipment, net 791,800 Total property, plant, and equipment 916,800 Intangible asset – copyright 16,000 Total assets$1,566,800

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones9 - 7 The Classified Balance Sheet Liabilities: Current liabilities: Accounts payable$501,000 Accounts payable$501,000 Short-term note payable 50,000 Short-term note payable 50,000 Total current liabilities$551,000 Long-term liabilities: Bonds payable 350,000 Bonds payable 350,000 Total liabilities$901,000

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones9 - 8 The Classified Balance Sheet Stockholders’ equity: Contributed capital: Common stock, $1 par value, 100,000authorized, 10,000 Common stock, $1 par value, 100,000authorized, 10,000 shares issued and outstanding:$ 10,000 Additional paid-in capital 390,000 Additional paid-in capital 390,000 Total contributed capital$400,000 Retained earnings 265,800 Total stockholders’ equity 665,800 Total liabilities and stockholders’ equity$1,566,800 $1,566,800 = $901,000 + $665,800

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones9 - 9 Assets Current assets are defined as assets that are cash already or are expected to become cash. One year Operating cycle Cash equivalents are marketable securities that will be converted into cash within 90 days.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Assets Long-term assets are expected to benefit the organization for more than one year. Long-terminvestments Property, plant, and equipment Intangibleassets

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Liabilities Current liabilities are those that require settlement within one year or the current operating cycle, whichever is longer. Long-term liabilities are those that do not require settlement within one year or the current operating cycle.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Examples of Current and Long-Term Assets Long-Term Long-term investments Property, plant, and equipment Intangible assets Other long-term assets Current Cash Marketable securities Accounts receivable Inventory Prepaid expenses

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Examples of Current and Long-Term Liabilities Long-Term Notes payable Mortgages payable Bonds payable Others Current Accounts payable Notes payable Accrued expenses Unearned revenue Payable for: Wages, taxes, interest, others Wages, taxes, interest, others Current portion of long-term debt Current portion of long-term debt

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Owners’ Equity Contributed capital The amount paid into the company by its owners Retained earnings Earnings reinvested by the corporation

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 3 Explain why recurring and nonrecurring items are presented separately on the income statement.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Organization of the Income Statement Eliason and Company Income Statement For the Year Ended December 31, 2004 Revenue$752,500 Less: Expenses 840,400 Net loss$ (87,900)

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Eliason and Company Income Statement Sales revenue$752,500 Less: Cost of goods sold 352,800 Gross profit on sales$399,700 Less operating expenses: Selling$60,250 Selling$60,250 General and administrative 96,250 General and administrative 96,250 Total operating expenses 156,500 Operating income$243,200 Less other expenses: Interest expense 30,650 Interest expense 30,650 Income before taxes and extraordinary item$212,550 Less income taxes 64,660 Income before extraordinary item$147,890 Extraordinary loss (less taxes of $87,420)–235,790 Net loss $ (87,900)

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Nonrecurring Items Nonrecurring items (net of tax) – Discontinued operations – Extraordinary items – Cumulative effect of changes in accounting principles

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Partial Income Statement for Toy Box, Inc., Year Ended 12/31/2005 Income from continuing operations$ 96,390 Discontinued operations: Income from discontinued operations Income from discontinued operations ($118,800, less: Income taxes of $47,520)$71,280 ($118,800, less: Income taxes of $47,520)$71,280 Loss on disposal of discontinued operations Loss on disposal of discontinued operations ($90,000, less: Income taxes of $36,000)–54,000 17,280 ($90,000, less: Income taxes of $36,000)–54,000 17,280 Income before extraordinary item and cumulative effect of a change in cumulative effect of a change in accounting principle$113,670 accounting principle$113,670 Extraordinary gain ($220,000, less: Taxes of $88,000) 132,000 Income before cumulative effect of a change in accounting principle$245,670 change in accounting principle$245,670 Cumulative effect of a change in accounting principle ($62,000, less: Taxes of $24,800)– 37,200 principle ($62,000, less: Taxes of $24,800)– 37,200 Net income$208,470

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 4 Interpret the net of tax disclosure of discontinued operations, extraordinary items, and accounting changes.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Income Tax Disclosure The accounting profession has decided that the only tax expense shown on the income statement as a separate line item will be the amount associated with continuing operations. Nonrecurring items on the income statement are shown “less income tax” or “net of tax.”

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Income Tax Disclosure Income from discontinued operations: $118,000 × 40% = $47,520 tax $118,000 – $47,520 tax = $71,280 Loss on disposal of discontinued operation: $90,000 × 40% = $36,000 tax $90,000 – $36,000 tax savings = $54,000 loss

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Effect of Tax on Gains and Losses Gain Tax lessens gain Net of tax gain Total gain Loss Tax lessens loss Net of tax loss Total loss

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Discontinued Operations Income or loss of a segment that is to be eliminated, and any gain or loss from the actual disposal of that segment, are reported as nonrecurring items on the income statement. A business segment may be a portion of an entity representing either a separate major line of business or a class of customer.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Extraordinary Items An extraordinary item is an event that is both unusual in nature and infrequent in occurrence. It can’t be just one or the other, it most be both. Significant items that are either unusual in nature or infrequent in occurrence are listed under other gains and losses. They should not be shown net of tax.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Extraordinary Items Although they are not necessarily unusual and infrequent, accounting rules require that any gain or loss resulting from extinguishment of debt must be reported as extraordinary.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Change in Accounting Principles This nonrecurring item can result from either of two scenarios: The adoption of a new accounting standard Change from one acceptable accounting method to another

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Change in Accounting Principles The cumulative effect of an accounting change is the total of the difference between the prior income a company actually reported, and the income the company would have reported if the company had used the newly adopted accounting principle all along.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Comprehensive Income Income from the income statement Other comprehensive income Foreign currency Certain pension liabilities Unrealized holding gains and losses Comprehensive income

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Comprehensive Income A separate statement of comprehensive income A combined statement of income and comprehensive income Comprehensive income included in the statement of changes in stockholders’ equity

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 5 Calculate earnings per share and describe how it is presented on the income statement.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Stockholders’ Equity Section of Toy Box, Inc.’s Balance Sheet December Contributed Capital: 4% Preferred stock, $100 par value 4% Preferred stock, $100 par value 5,000 shares authorized, issued, 5,000 shares authorized, issued, and outstanding$ 500,000$ 500,000 and outstanding$ 500,000$ 500,000 Common stock, $10 par value, Common stock, $10 par value, Authorized shares: 100,000 Authorized shares: 100,000 issued and outstanding: issued and outstanding: 2005: 90,000; 2004: 85, , , : 90,000; 2004: 85, , ,000 Additional paid-in capital 450, ,000 Additional paid-in capital 450, ,000 Total contributed capital$1,850,000$1,740,000 Retained earnings 794, ,580 Total stockholders’ equity$2,644,050$2,415,580

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Earnings Per Share Basic earnings per share is earnings per common share based on the average number of common shares outstanding during the year. Basic earnings per share = (Net income – Preferred dividends) ÷ Weighted average number of common shares outstanding

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Earnings Per Share Assume that during 2005, Toy Box had 85,000 common shares outstanding for three months of the year and 90,000 shares outstanding for the remaining nine months. What is the weighted average number of common shares outstanding?

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Earnings Per Share Number of Period Weighted Dates Shares Outstanding of Time Amount 1/1 to 3/3185,000×3/1221,250 4/1 to 12/3190,000×9/1267,500 Weighted average shares88,750 How much are the preferred dividends? $500,000 × 4% = $20,000

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Earnings Per Share ($208,470 – $20,000) ÷ 88,750 = $2.12 What are the earnings per share? Assume that each of the 5,000 shares of Toy Box’s 4% preferred stock is convertible to 6 shares of common stock, a total of 30,000 shares.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Diluted Earnings Per Share What are the diluted earnings per share? (Adjusted net income – Adjusted preferred dividends) ÷ Adjusted weighted average number of common shares outstanding ($208,470 – $0) ÷ (88, ,000) = $1.76

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Earnings Per Share Income Statement Presentation Income from continuing operations$0.86$0.81 Income from discontinued operations, net of income tax operations, net of income tax Loss on disposal of discontinued operation, net of income tax–0.61–0.45 operation, net of income tax–0.61–0.45 Gain from discontinued operation, net of income tax$0.19$0.15 operation, net of income tax$0.19$0.15 Income before extraordinary item and cumulative change in accounting principle$1.05$0.96 cumulative change in accounting principle$1.05$0.96 Extraordinary gain, net of income tax Income before cumulative effect of a change in accounting principle$2.54$2.07 a change in accounting principle$2.54$2.07 Cumulative effect of a change in accounting principle, net of tax–0.42–0.31 accounting principle, net of tax–0.42–0.31 Net income$2.12$1.76 Earnings per Common ShareBasic Diluted

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 6 Describe the additional information provided by comparative financial statements.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Comparative Financial Statements Norton Tire Company, Inc. Income Statements For the Years Ended December 31, 2003, 2002, and 2001 (in thousands) Sales$14,745$12,908$10,888 Less: Cost of goods sold 10,213 8,761 7,661 Gross profit on sales$ 4,532$ 4,147$ 3,227 Selling, general, and administrative expenses 3,627 2,997 2,087 administrative expenses 3,627 2,997 2,087 Operating income$ 905$ 1,150$ 1,140 Interest expense Income before taxes$ 760$ 1,012$ 1,033 Income taxes Net income$ 494$ 658$

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Comparative Financial Statements Assets: Current assets: Cash$ 2,240$1,936 Cash$ 2,240$1,936 Accounts receivable 2,340 2,490 Accounts receivable 2,340 2,490 Merchandise inventory Merchandise inventory Prepaid expenses Prepaid expenses Total current assets$ 5,556$5,279 Property, plant, and equipment: Buildings, net$ 4,046$2,889 Buildings, net$ 4,046$2,889 Equipment, net 1, Equipment, net 1, Total plant and equipment$ 5,169$3,753 Total assets$10,725$9,

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Comparative Financial Statements Liabilities: Current liabilities: Accounts payable$ 1,616$1,080 Accounts payable$ 1,616$1,080 Notes payable 2,720 2,920 Notes payable 2,720 2,920 Total current liabilities$ 4,336$4,000 Long-term liabilities 2,000 1,600 Total liabilities$ 6,336$5,600 Stockholders’ equity: Common stock, no par value$ 3,000$2,400 Retained earnings 1,389 1,032 Total stockholders’ equity$ 4,389$3,432 Total liabilities and stockholders’ equity$10,725$9,032 stockholders’ equity$10,725$9,

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 7 Calculate several financial ratios based on income statement and balance sheet information.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Using Financial Information The asset turnover ratio shows the amount of sales produced for a given level of assets used. Asset turnover ratio = Net sales ÷ Average total assets Norton’s asset turnover ratio = $14,745 ÷ $9, = 1.49 times

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Receivables turnover ratio = Net sales ÷ Average accounts receivable The receivables turnover ratio measures how efficiently a company manages its accounts receivable. Norton’s receivables turnover ratio = $14,745 ÷ $2,415 = 6.11 times Using Financial Information

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Average accounts receivable collection period in days = 365 ÷ Accounts receivable turnover Using Financial Information Norton’s average collection period = 365 ÷ 6.11 = days

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Current ratio = Current assets ÷ Current liabilities The current ratio measures the company’s ability to meet its short-term financial obligations with current assets. Norton’s current ratio = $5,556 ÷ $4,336 = 1.28 Using Financial Information

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Quick ratio = (Cash + Short-term investments + Current receivables) ÷ Current liabilities The quick ratio considers only current assets that are highly liquid in the numerator. Using Financial Information

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Times-interest-earned = Earnings before interest and income taxes ÷ Interest expense Times-interest-earned ratio indicates a company’s ability to earn (cover) its periodic interest payments. Using Financial Information

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones End of Chapter 9