Copyright©2001 by Houghton Mifflin Company. All rights reserved. 1 Financial Accounting Belverd E. Needles, Jr. Marian Powers Multimedia Slides by: Dr. Howard A. Kanter, CPA DePaul University Milton M. Pressley University of New Orleans

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 2 LEARNING OBJECTIVES 1.State the objectives of financial reporting. 2.State the qualitative characteristics of accounting information and describe their interrelationships. comparability consistency, materiality, conservatism, full disclosure, cost-benefit. 3.Define and describe the use of the conventions of comparability and consistency, materiality, conservatism, full disclosure, and cost-benefit. fraudulent financial reporting. 4.Explain management’s responsibility for ethical financial reporting and define fraudulent financial reporting.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 3 5.Identify and describe the basic components of a classified balance sheet. 6.Prepare multi-step and single-step classified income statements. 7.Evaluate liquidity and profitability using classified financial statements. LEARNING OBJECTIVES (continued) LEARNING OBJECTIVES (continued)

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 4 Objectives of Financial Information OBJECTIVE 1 State the objectives of financial reporting.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 5 Objectives of Financial Reporting 1.To furnish information useful in making investment and credit decisions. 2.To provide information useful in assessing cash flow prospects. 3.To provide information about business resources, claims to those resources, and changes in them. u The needs of users and the general business environment are the basis for the FASB’s three objectives of financial reporting:

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 6 Qualitative Characteristics of Accounting Information OBJECTIVE 2 OBJECTIVE 2 State the qualitative characteristics of accounting information and describe their interrelationships.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 7 Qualitative Characteristics of Accounting Information u Qualitative characteristics of accounting information are standards for judging that information. understandability usefulness u The two qualitative characteristics are understandability and usefulness.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 8Understandability u The accountant prepares financial statements according to accepted practices that are believed to be understandable. u Decision makers must interpret accounting information and use it in making decisions.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 9Usefulness relevantreliable u To be useful, accounting information must be relevant and reliable. u Relevance u Relevance means the information can affect the outcome of a decision. 4 Provide feedback. 4 Help predict future conditions. 4 Be timely.

Copyright©2001 by Houghton Mifflin Company. All rights reserved Must represent what it is meant to represent. 4 Must be credible. 4 Must be verifiable by independent parties using the same methods of measuring. 4 Must be neutral. u Reliability u Reliability means the user must be able to depend on the information.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 11 Conventions That Help in the Interpretation of Financial Information OBJECTIVE 3 OBJECTIVE 3 comparability consistency, materiality, conservatism, full disclosure, cost-benefit. Define and describe the use of the conventions of comparability and consistency, materiality, conservatism, full disclosure, and cost-benefit.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 12Comparability u Information is presented in such a way that a decision maker can recognize similarities, differences, and trends over different time periods or between different companies. u Accounting information about a company is more useful if it can be compared with similar facts about the same company over several time periods or about another company for the same time period.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 13Consistency u An accounting procedure, once adopted by a company, remains in use from one period to the next unless users are informed of the change. u GAAP requires that the change and its dollar effect be described in the notes to the financial statements.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 14Materiality u Materiality refers to the relative importance of an item or event. u An item is material if users would have done something differently if they had not known about the item. u Materiality is normally determined by relating its dollar value to an element of the financial statements, such as net income or total assets. u Some accountants follow the 5% or more of net income rule to judge materiality.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 15Conservatism u When accountants face major uncertainties about which accounting procedure to use, they generally choose the one that is least likely to overstate assets and income. u Abuse of the conservatism principle may lead to financial statements that are misleading.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 16 Full Disclosure u Full disclosure requires that financial statements and their notes present all information that is relevant to the users’ understanding of the statements. u Beyond required disclosures, application of full disclosure is based on the judgment of management and the accountants who prepare the financial statements. u The demands for full disclosure have increased in recent years.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 17Cost-Benefit u Benefits to be gained from providing accounting information should be greater than the costs of providing it. u Beyond providing minimum levels of relevance and reliability, cost- benefit is based on professional judgment.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 18 Management’s Responsibility for Ethical Reporting OBJECTIVE 4 OBJECTIVE 4 fraudulent financial reporting. Explain management’s responsibility for ethical financial reporting and define fraudulent financial reporting.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 19 Fraudulent Financial Reporting u The intentional preparation of misleading financial statements. u The distortion of records (manipulation of inventory records). u Falsified transactions (fictitious sales or orders). u The misapplication of accounting principles (treating as an asset an item that should be expensed).

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 20 Possible Motives for Fraudulent Financial Reporting u To obtain a higher price when a company is sold. u To meet the expectations of stockholders. u To obtain a loan. u For personal gain.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 21 Classified Balance Sheet OBJECTIVE 5 OBJECTIVE 5 Identify and describe the basic components of a classified balance sheet.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 22Assets 1.Current assets. 2.Investments. 3.Property, plant, and equipment. 4.Intangible assets. u Assets are divided into four categories.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 23 Current Assets u Cash and other assets that are reasonably expected to be realized in cash, sold, or consumed over the next year or the normal operating cycle of the business, whichever is longer. u Cash to cash cycle. u Listed in order of decreasing liquidity.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 24Investments u Investments are assets, usually long term, that are not used in the normal operations of the business and that management does not plan to convert to cash within the next year.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 25 Property, Plant, and Equipment u Long-term assets used in the continuing operation of the business. u Also called fixed, operating, long-lived, or tangible assets. u Often abbreviated PP&E.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 26 Intangible Assets u Intangible assets are long-term assets that have no physical substance but have a value based on the rights or privileges that belong to their owner.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 27 Other Assets u Other assets are sometimes used for all owned assets other than current assets and PP&E.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 28Liabilities u Liabilities are divided into two categories. 1.Current liabilities. 2.Long-term liabilities.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 29 Current Liabilities u Current liabilities are obligations due to be paid or performed within a year or within the normal operating cycle of the business, whichever is longer.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 30 Long-Term Liabilities u Long-term liabilities are the debts of a business that fall due more than one year in the future or beyond the normal operating cycle, or that are paid out of non-current assets.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 31 Stockholders’ Equity u Stockholders’ equity is divided into two categories. 1.Contributed or paid-in capital. 2.Retained earnings.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 32 Multi-step Income Statement OBJECTIVE 6 Prepare multi-step and single-step classified income statements.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 33 Multi-step Income Statement u Multi-step income statement derives net income in a step-by- step manner; however, it shows only the totals of major categories.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 34 Multi-step Income Statement: A Merchandising Company u Net sales u Cost of goods sold u Gross margin u Operating expenses u Income from operations u Other revenues and expenses u Income before income taxes u Income taxes u Net income u Earnings per share

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 35 Single-Step Income Statement u Single-step income statement derives income before income taxes in a single step by putting the major revenue categories in the first part of the statement and by putting the major cost and expense categories in the second part of the statement. u Income taxes shown as a separate item. u Simple presentation.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 36 Using Classified Financial Statements OBJECTIVE 7 OBJECTIVE 7 Evaluate liquidity and profitability using classified financial statements.

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 37 Evaluation of Liquidity: Working Capital u The amount by which total current assets exceed total current liabilities. Current assets Current assets $124,356 Current liabilities Current liabilities $42,683 Working capital Working capital $81,673

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 38 Evaluation of Liquidity: Current Ratio u The ratio of current assets to current liabilities. u Compare to last year and industry. Current assets $123,356 Current liabilities $ 42,683 = = 2.9

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 39 Evaluation of Profitability: Profit Margin u The percentage of each sales dollar that results in net income. Net income $ 14,500 Net sales $289,656 ==.05

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 40 Evaluation of Profitability: Asset Turnover u Measure of how efficiently assets are used. Net sales$289,656 Average total assets$153,768 == 1.9 times

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 41 Evaluation of Profitability: Return on Assets u Measure of how efficiently assets are used. u Considers assets and income. Net income $ 14,500 Average total assets $153,768 ==.094

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 42 Evaluation of Profitability: Debt to Equity u Proportion of company financed by creditors compared to the amount financed by investors. Total liabilities $60,483 Stockholders’ equity $98,433 = =.614

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 43 Evaluation of Profitability: Return on Equity u Measure of how much shareholders have earned on their investment. Net income $14,500 Average stockholders’ equity $99,492 ==.146