A Further Look at Financial Statements Chapter 2

# 1 Generally Accepted Accounting Principles GAAPGAAP Agreed-upon accounting rulesAgreed-upon accounting rules Most U.S. companies useMost U.S. companies use Promulgated by Financial Accounting Standards Board - FASBPromulgated by Financial Accounting Standards Board - FASB

# 1 Basic Objective of Financial Reporting Provide information useful for decision making

Recall Content and Purpose of Financial Statements Recall Content and Purpose of Financial Statements Income StatementIncome Statement Retained Earnings StatementRetained Earnings Statement Balance SheetBalance Sheet Statement of Cash FlowsStatement of Cash Flows

Recall Users of Financial Statements Recall Users of Financial Statements Internal UsersInternal Users External UsersExternal Users

# 2 Qualitative Characteristics of Accounting Information RelevanceRelevance ReliabilityReliability ComparabilityComparability ConsistencyConsistency

Relevance Makes a difference to the decisionMakes a difference to the decision Confirms or corrects prior expectations, feedback valueConfirms or corrects prior expectations, feedback value Helps predict future eventsHelps predict future events It is timelyIt is timely

Reliability Can be depended uponCan be depended upon Verifiable – free of errorVerifiable – free of error Faithful representation - factualFaithful representation - factual Neutral – does not favor anyoneNeutral – does not favor anyone

Comparability & Consistency Comparability – different companies use similar accounting policiesComparability – different companies use similar accounting policies Comparability – a firm uses similar accounting policies year to yearComparability – a firm uses similar accounting policies year to year

# 3 Constraints in Accounting MaterialityMateriality ConservatismConservatism

Materiality Will it influence the decision?Will it influence the decision? –MATERIAL No impact on decision?No impact on decision? –IMMATERIAL © PhotoDisc/Getty Images

Conservatism When in doubt, choose method least likely to overstate assets and income Do not intentionally understate!

# 4 Identify the Sections of a Classified Balance Sheet Helps users see if company has enough assets to pay debtsHelps users see if company has enough assets to pay debts Can determine the short-term and long-term claims on total assetsCan determine the short-term and long-term claims on total assets

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

Current Assets Assets that are expected to be converted to cash or used in the business within one year. Current assets are listed in order of liquidity, or how quickly they will convert to cash or be used up...

Current Assets Examples: –Cash –Short-term investments –Receivables –Inventories –Supplies –Prepaid expenses

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.

Long-Term Investments Example: –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: –land –buildings –machinery –delivery equipment –furniture and fixtures Digital Vision

Property, Plant, and Equipment - Depreciation Depreciation expense allocates asset’s full purchase price to a number of years (on Income Statement) Balance sheet shows total amount of depreciation taken over the life of the asset in the Accumulated Depreciation account

Property, Plant, and Equipment - Depreciation

Intangible Assets Non-current assets No physical substance

Current Liabilities Obligations that are supposed to be paid within the coming year...

Current Liabilities accounts payable wages payable bank loans payable interest payable taxes payable current maturities of long-term loans payable

Long-Term Liabilities Debts expected to be paid after one year Examples… – bonds payable – mortgages payable – long-term notes payable – lease liabilities – obligations under employee pension plans

Stockholders' Equity Capital (Common) stock - investments in the business by the stockholders Retained earnings – net income retained for use in the business

Ratio Analysis Expresses relationship among selected items of financial statement data Relationship can be expressed in terms of… –Percentage –Rate –Proportion

Ratio Analysis - Classifications Liquidity RatiosLiquidity Ratios - measure short-term ability of company to pay maturing obligations and meet unexpected needs for cash

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

Ratio Analysis - Classifications Solvency RatiosSolvency Ratios - Measures of the ability of the company to survive over a long period of time

Ratio Analysis – Use Multiple Measures! Intracompany comparisonsIntracompany comparisons - covering two years of the same company Industry average comparisonsIndustry average comparisons - based on average ratios for a particular industry Intercompany comparisonsIntercompany comparisons - based on comparisons with a competitor in the same industry

Profitability Ratios Measures operating success (income) of a company for a given period of time Two examples: –Earnings Per Share (EPS) –Price- Earnings Ratio (P-E)

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=

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

Ratio Examples

# 7 Identify and Compute Ratios for Analyzing a Company’s Liquidity and Solvency Using a Balance Sheet

Financial Ratio Classifications Liquidity RatiosLiquidity Ratios - measures of short-term ability to pay maturing obligations and to meet unexpected needs for cash Working capitalWorking capital Current ratioCurrent ratio

Working Capital Working Capital = Current Assets - Current Liabilities Measure of short-term ability to pay obligations Difference between current assets and current liabilities Positive working capital is favorable!

Current Ratio Current Ratio = Current Assets Current Liabilities Another measure of short-term ability to pay obligations Divide current assets by current liabilities More dependable indicatorMore dependable indicator Does not consider composition of current assetsDoes not consider composition of current assets

Current Ratio Industry average means?

Current Ratio Industry means? Industry average means? $1.49 of current assets for every $1 of current debt

Financial Ratio Classifications Solvency RatiosSolvency Ratios - measures of the ability of a company to survive over a long period of time Debt to Total Assets RatioDebt to Total Assets Ratio

Debt to Total Assets Ratio Divide total debt (current and long-term liabilities) by total assets Total Debts Total Assets Debt to Total Asset Ratio = Measures percentage of assets financed by creditors rather than stockholdersMeasures percentage of assets financed by creditors rather than stockholders

Let’s Review Selected financial information for Drummond Company at 12/31/2005: Let’s compute current ratio...

Let’s Review – Compute Current Ratio $210,000 $140,000 = 1.5 : 1 

Let’s Review Selected financial information for Drummond Company at 12/31/2005: Now, let’s compute debt to total assets...

Let’s Review – Compute Debt to Total Assets $270,000  $540,000 = 50%