Needles Powers Crosson Principles of Accounting 12e Foundations of Financial Reporting and the Classified Balance Sheet 5 C H A P T E R © human/iStockphoto

LEARNING OBJECTIVES ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  LO1: Describe the objective of financial reporting, and identify the conceptual framework underlying accounting information.  LO2: Identify and define the basic components of financial reporting, and prepare a classified balance sheet  LO3: Use classified financial statements to evaluate liquidity and profitability.

SECTION 1: CONCEPTS (slide 1 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Relevance: information has a direct bearing on a decision –Predictive value: information helps capital providers make decisions about future actions –Confirmative value: information confirms or changes previous evaluations –Materiality: the omission or misstatement of information could influence the user’s economic decisions taken on the basis of the financial statements  Faithful representation: information is complete, neutral, and free from material error –Completeness: all information necessary for a reliable decision is provided –Neutrality: information is free from bias intended to achieve a certain result or bring about a particular behavior –Free from material error: information meets a minimum level of accuracy so it does not distort what is being reported

SECTION 1: CONCEPTS (slide 2 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Enhancing qualitative characteristics –Comparability: the quality that enables users to identify similarities and differences between two sets of financial data –Verifiability: the quality that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation –Timeliness: the quality that enables users to receive information in time to influence their decisions –Understandability: the quality that enables users to comprehend the meaning of information –Cost constraint (cost-benefit): the benefits to be gained from providing accounting information should be greater than the costs of providing it

SECTION 1: CONCEPTS (slide 3 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Accounting conventions: constraints used in preparing financial statements –Consistency: once a company has adopted an accounting procedure, it must use it from one period to the next unless a note to the financial statements informs users of a change –Full disclosure (transparency): financial statements must present all the information relevant to users’ understanding of the statements –Conservatism: when faced with choosing between two equally acceptable procedures or estimates, accountants should choose the one that is least likely to overstate assets and income

Objective of Financial Reporting  To be useful for decision making, financial reporting must enable the user to –Assess cash flow prospects –Assess management’s stewardship  Financial reporting includes the financial statements (balance sheet, income statement, statement of owner’s equity, and statement of cash flows) that are prepared periodically. –Management’s underlying assumptions and methods and estimates used in the financial statements are also important components of financial reporting. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Qualitative Characteristics of Accounting Information  To facilitate interpretation of accounting information, the FASB has established standards, or qualitative characteristics, by which to judge the information.  The most fundamental of these characteristics are: –Relevance –Faithful representation ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Relevance (slide 1 of 2)  Relevance means that the information has a direct bearing on a decision. In other words, if the information were not available, a different decision would be made. –To be relevant, information must have one or both of the following:  Predictive value—Information has predictive value if it helps capital providers make decisions about future actions.  Confirmative value—Information has confirmative value if it confirms or changes previous evaluations. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Relevance (slide 2 of 2)  Relevant information is also subject to materiality. –Information is material if its omission or misstatement could influence the user’s economic decisions taken on the basis of the specific entity’s financial statements. –Materiality is related to both the nature of an item and its size or misstatement.  The materiality of an item normally is determined by relating its dollar value to an element of the financial statements, such as net income or total assets.  As a rule, when an item is worth 5 percent or more of net income, accountants treat it as material.  However, many small errors can add up to a material amount. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Faithful Representation  Faithful representation means that the financial information is complete, neutral, and free from material errors. –Complete information provides all information necessary for a reliable decision. –Neutral information is free from bias intended to achieve a certain result or to bring about a particular behavior. –To be free from material error means information meets a minimum level of accuracy so it does not distort what is being reported. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Enhancing Qualitative Characteristics (slide 1 of 2)  Other characteristics that the FASB has established for interpreting accounting information include: –Comparability—enables users to identify similarities and differences between two sets of financial data. –Verifiability—different knowledgeable and independent observers could reach consensus that a particular depiction is a faithful representation. –Timeliness—enables users to receive information in time to influence their decisions. –Understandability—enables users to comprehend the meaning of the information. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Enhancing Qualitative Characteristics (slide 2 of 2)  These enhancing characteristics are subject to the cost constraint (or cost-benefit), which holds that the benefits to be gained from providing accounting information should be greater than the costs of providing it. –Minimum levels of relevance and faithful representation must be reached if accounting information is to be useful. –Beyond the minimum levels, it is up to the FASB, the SEC, and the accountant who provides the information to judge the costs and benefits in each case. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounting Conventions (slide 1 of 2)  Accounting conventions, or constraints, used in preparing financial statements include: –Consistency—requires that once a company has adopted an accounting procedure, it must use it from one period to the next unless a note to the financial statements informs users of a change. –Full disclosure (or transparency)—requires that financial statements present all the information relevant to users’ understanding of the statements, including:  any explanation needed to keep them from being misleading.  the disclosure of significant events arising after the balance sheet date. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounting Conventions (slide 2 of 2) –Conservatism—holds that, when faced with choosing between two equally acceptable procedures or estimates, the accountant should choose the one that is least likely to overstate assets and income.  Conservatism can be a useful tool, but if abused, can lead to incorrect or misleading financial statements.  Accountants should apply the conservatism convention only when they are uncertain about which accounting procedure or estimate to use. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Ethical Financial Reporting  Under the Sarbanes-Oxley Act, chief executive officers and chief financial officers of all publicly traded companies must certify that, to their knowledge, their quarterly and annual statements are accurate and complete.  Fraudulent financial reporting can have high costs for investors, lenders, employees, and customers— as well as for the people who condone, authorize, or prepare misleading reports. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Classified Balance Sheet  General-purpose external financial statements that are divided into subcategories are called classified financial statements.  The subcategories into which assets, liabilities, and owner’s equity are broken down are shown below. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Assets  The classified balance sheet typically divides assets into four categories: current assets; investments; property, plant, and equipment; and intangible assets.  These categories are listed in the order of how easily they can be converted to cash.  Some companies group investments, intangible assets, and other miscellaneous assets into a category called other assets. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Assets  Current assets include cash and other assets that a company can reasonably expect to convert to cash, sell, or consume within one year or its normal operating cycle, whichever is longer. –A company’s normal operating cycle is the average time it needs to go from spending to receiving cash. –Current assets include: cash; short-term investments; notes and accounts receivable; inventory that a company expects to convert to cash (by selling it) within the next year or the normal operating cycle; prepaid expenses; and supplies bought for use. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Investments –Securities held for long-term investment –Long-term notes receivable –Land held for future use –Plant or equipment not used in business –Special funds established to pay off a debt or buy a building –Large permanent investments made in another company for the purpose of controlling that company ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Investments include assets, usually long-term, that are not used in normal business operations and that management does not plan to convert to cash within the next year. Examples include:

Property, Plant, and Equipment  Property, plant, and equipment include tangible long- term assets used in a business’s day-to-day operations. –They are also called operating assets, fixed assets, tangible assets, long-lived assets, or plant assets. –Through depreciation, the costs of these assets (except land) are spread over the periods they benefit. –To reduce clutter on the balance sheet, property, plant, and equipment and related accumulated depreciation accounts are often combined—for example: Property, plant, and equipment (net)$116,240 ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Intangible Assets  Intangible assets are long-term assets with no physical substance. Their value stems from the rights or privileges accruing to their owners. Examples include: –Patents –Copyrights –Franchises –Trademarks –Goodwill—arises in an acquisition of another company ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Liabilities - Current liabilities— obligations that must be satisfied within one year or within the company’s normal operating cycle, whichever is longer.  Notes payable  Accounts payable  Current portion of long-term debt  Salaries and wages payable  Customer advances - Long-term liabilities— debts that fall due more than one year in the future or beyond the normal operating cycle.  Mortgages payable  Long-term notes  Bonds payable  Employee pension obligations  Long-term lease liabilities ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Liabilities are divided into two categories:

Owner’s Equity  The terms owner’s equity, proprietorship, owner’s capital, and net worth are all used to refer to the owner’s interest, or equity, in a company. –The first three terms are preferred to net worth because many assets are recorded at their original cost rather than at their current value.  The equity section of the balance sheet differs depending on whether the business is a sole proprietorship, partnership, or corporation. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Sole Proprietorship  The owner’s equity section of a sole proprietorship would be similar to the one shown for Bonali Company: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Partnership  The equity section of a partnership’s balance sheet is called partners’ equity.  It is much like that in a sole proprietorship’s balance sheet and might appear as follows: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Corporation (slide 1 of 2)  The equity section of a balance sheet for a corporation is called stockholders’ equity (or shareholders’ equity).  It has two parts, contributed capital and retained earnings.  The Contributed Capital (or Paid-in Capital) account reflects the amount of assets invested by stockholders.  It is generally shown on corporate balance sheets by two amounts: –the face, or par, value of issued stock –the amounts paid in, or contributed, in excess of the par value per share ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Corporation (slide 2 of 2)  The Retained Earnings account is sometimes called Earned Capital because it represents the stockholders’ claim to the assets that are earned from operations and reinvested in corporate operations.  Distributions of assets to shareholders, which are called dividends, reduce the Retained Earnings account just as withdrawals of assets by the owner of a business reduce the Capital account. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Overview of Classified Balance Sheet Accounts  Similar accounts on the balance sheet and income statement can be grouped, as shown below. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Using Classified Financial Statements  Ratios use the components of classified financial statements to reflect how well a firm has performed in terms of maintaining liquidity and achieving profitability.  Accounts must be classified correctly before the ratios are computed, or the ratios will be incorrect. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluation of Liquidity  Liquidity means having enough money on hand to pay bills when they are due and to take care of unexpected needs for cash. Two measures of liquidity are working capital and current ratio.  Working capital is the amount by which current assets exceed current liabilities. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Ratio  The current ratio is the ratio of current assets to current liabilities.  To determine whether a current ratio is good or bad, it must be compared with ratios for earlier years and with similar measures for companies in the same industry. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluation of Profitability  Profitability is the ability to earn a satisfactory income. –Profitability competes with liquidity because liquid assets are not the best profit-producing resources. –Ratios commonly used to evaluate a company’s ability to earn income include:  Profit margin  Asset turnover  Return on assets  Debt to equity ratio  Return on equity ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Profit Margin  The profit margin shows the percentage of each sales dollar that results in net income. –It is an indication of how well a company is controlling its costs: the lower its costs, the higher its profit margin. –To determine whether this is a satisfactory profit, it must be compared with the profit margin of other companies in the same industry. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Asset Turnover  The asset turnover ratio measures how efficiently assets are used to produce sales. –A company with a high asset turnover uses its assets more productively than one with a low asset turnover. –Asset turnover is computed by dividing revenues by average total assets. Average total assets are the sum of assets at the beginning and the end of the period, divided by 2. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Return on Assets  The return on assets ratio relates net income to average total assets. –This ratio combines the firm’s income-generating strength (profit margin) and its revenue-generating effectiveness (asset turnover). ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Debt to Equity Ratio  The debt to equity ratio shows the proportion of a company’s assets financed by creditors and the proportion financed by the owner. –This ratio is relevant to profitability, as well as liquidity, because the more debt a company has, the more profit it must earn to ensure payment of interest to creditors and a return on the owner’s investment. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Return on Equity  Return on equity is the ratio of net income to average owner’s equity. –Return on equity will always be greater than return on assets because total equity will always be less than total assets. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.