Financial & Managerial Accounting 2002e

Financial & Managerial Accounting 2002e
Belverd E. Needles, Jr. Marian Powers Susan Crosson Multimedia Slides by: Harry Hooper Santa Fe Community College Copyright © by Houghton Mifflin Company. All rights reserved.

Chapter 5 Financial Reporting and Analysis

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

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

Objectives of Financial Information
State the objectives of financial reporting.

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

Discussion Q. What are the three objectives of financial reporting? A. According to the Financial Accounting Standards Board, the three objectives of financial reporting are: (1) to furnish information useful in making investment and credit decisions; (2) to provide information useful in assessing cash flow prospects; and (3) to provide information about business resources, claims to those resources, and changes in them. Copyright © by Houghton Mifflin Company. All rights reserved.

Qualitative Characteristics of Accounting Information
OBJECTIVE 2 State the qualitative characteristics of accounting information and describe their interrelationships.

Qualitative Characteristics of Accounting Information (continued…)
Qualitative characteristics of accounting information are standards for judging accounting information. The two qualitative characteristics are understandability and usefulness. Copyright © by Houghton Mifflin Company. All rights reserved.

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

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

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

Discussion (continued…)
A. Qualitative characteristics are standards for judging the information that accountants give to decision makers. Accountants try to provide information that is understandable and useful. Understandable means that the user is able to interpret the information. Usefulness depends on the characteristics of relevance and reliability. Relevance requires that the information give feedback, help make predictions, and be timely. Reliability requires that the information represent what it is supposed to represent, and be credible, verifiable, and neutral. Copyright © by Houghton Mifflin Company. All rights reserved.

Conventions That Help in the Interpretation of Financial Information
OBJECTIVE 3 Define and describe the use of the conventions of comparability and consistency, materiality, conservatism, full disclosure, and cost-benefit.

Comparability 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. Accounting information can be compared with similar facts about the same company over several time periods or about another company for the same time period. Copyright © by Houghton Mifflin Company. All rights reserved.

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

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

Conservatism 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. Abuse of the conservatism principle may lead to financial statements that are misleading. Copyright © by Houghton Mifflin Company. All rights reserved.

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

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

Discussion Q. What are the accounting conventions? A. The five conventions that help users interpret financial statements are: comparability and consistency, materiality, conservatism, full disclosure, and cost-benefit. Copyright © by Houghton Mifflin Company. All rights reserved.

Management’s Responsibility for Ethical Reporting
OBJECTIVE 4 Explain management’s responsibility for ethical financial reporting and define fraudulent financial reporting.

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

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

Discussion Q. Who is responsible for preparing reliable financial statements, and what is a principal way of fulfilling the responsibility? A. Management is responsible for the preparation of reliable financial statements. Management fulfills its responsibility by maintaining a system of internal controls. Copyright © by Houghton Mifflin Company. All rights reserved.

Classified Balance Sheet
OBJECTIVE 5 Identify and describe the basic components of a classified balance sheet.

Classified Balance Sheet
Financial Statements divided into useful subcategories are called classified financial statements. Setting up subcategories makes financial statements more useful. A classified balance sheet breaks assets, liabilities, and owner equity into subcategories. Copyright © by Houghton Mifflin Company. All rights reserved.

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

Investments 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. Securities Long-term notes receivable. Land held for future use. Plant or equipment not used in the business. Special funds to pay off debts or make a capital purchase. Long term investments in another company to control that company. Copyright © by Houghton Mifflin Company. All rights reserved.

Property, Plant, and Equipment
Long-term assets used in the continuing operation of the business, including natural resources. Also called fixed, operating, long-lived, or tangible assets. Accounts include asset accounts (and related contra accounts to accumulate past periodic cost allocations for each asset except land.) Copyright © by Houghton Mifflin Company. All rights reserved.

Intangible Assets 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. Patents Copyrights Goodwill Franchises Trademarks etc. Copyright © by Houghton Mifflin Company. All rights reserved.

Current Liabilities 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. Notes payable Accounts payable Current portion of long-term debt Salaries and wages payable Taxes payable Customer advances (unearned revenues) Copyright © by Houghton Mifflin Company. All rights reserved.

Long-Term Liabilities
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. Mortgages payable Long-term notes payable Bonds payable Employee pension obligations Long-term lease liabilities Copyright © by Houghton Mifflin Company. All rights reserved.

Stockholders’ Equity Contributed (or paid-in) capital. The face (or par) value of issued stock. The amounts paid in, or contributed, in excess of par. Retained Earnings The earnings of the corporation, less dividends paid to stockholders over the life of the corporation. Copyright © by Houghton Mifflin Company. All rights reserved.

Other Forms of Business Organization
The equity section of the balance sheet for a: Sole proprietorship – shows the capital in the owner’s name equal to the net assets of the company (Owner’s equity). Partnership – shows the capital in each partner’s name (Partner’s equity). Copyright © by Houghton Mifflin Company. All rights reserved.

No two companies will have financial statements that are exactly alike. Graphical presentations of the statements help visualize relative amounts or changes in the financial statements. Copyright © by Houghton Mifflin Company. All rights reserved.

Balance Sheet for Dell Computer Corp.
Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. How would a mortgage that is paid monthly for 120 months be classified? A. The portion due during the next year or the current operating cycle would be classified as a current liability; the portion due after next year or the current operating cycle would be classified as a long-term liability. Copyright © by Houghton Mifflin Company. All rights reserved.

Forms of the Income Statement
OBJECTIVE 6 Prepare multistep and single-step classified income statements.

Forms of the Income Statement
Internal management uses a detailed income statement for decision making. For external reporting, condensed financial statements showing only the major categories are used. Copyright © by Houghton Mifflin Company. All rights reserved.

Multistep Income Statement
Multistep income statement derives net income in a step-by-step manner. It shows only the totals of major categories. Copyright © by Houghton Mifflin Company. All rights reserved.

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

Single-Step Income Statement
Single-step income statement derives net income in a single step by putting the major revenue categories in the first part of the statement and by putting the major expense categories in the second part of the statement. Simple presentation. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. Why are other revenues and expenses separated from operating revenues and expenses in the multistep income statement? A. Other revenues and expenses are separated from operating revenues and expenses so that income from operations (the actual business of the company) can be isolated from the financing and non-operating aspects. Copyright © by Houghton Mifflin Company. All rights reserved.

Graphical Presentation of Dell Computer Corp’s Income Statement

Using Classified Financial Statements
OBJECTIVE 7 Evaluate liquidity and profitability using classified financial statements.

Evaluation of Liquidity
Liquidity – having enough money on hand to pay bills when they are due, and for unexpected cash needs. Working Capital Current assets minus current liabilities The net current assets on hand to continue business operations. Lack of working capital can lead to a company’s failure. Copyright © by Houghton Mifflin Company. All rights reserved.

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

Evaluation of Liquidity: Current Ratio
The ratio of current assets to current liabilities. Compare to last year and industry. Current assets $124,356 Current liabilities $42,683 Indicates a company’s ability to pay its bills and to repay loans. = = 2.9 Copyright © by Houghton Mifflin Company. All rights reserved.

Average Current Ratio for Selected Industries

Evaluation of Profitability: Profit Margin
Profitability – the ability to earn a satisfactory income. Profit Margin – the percentage of each sales dollar that results in net income. Net Income $ 17,881 Net Sales $289,656 = = Copyright © by Houghton Mifflin Company. All rights reserved.

Average Profit Margin for Selected Industries

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

Asset Turnover for Selected Industries

Evaluation of Profitability: Return on Assets
How efficiently assets are used to produce net income (profits.) Considers assets and income. Net income $ 17,881 Average total assets $153,768 = = .116 Copyright © by Houghton Mifflin Company. All rights reserved.

Return on Assets for Selected Industries

Return on assets combines profit margin and asset turnover: Net Income x Net Sales = Net income Net sales Average total assets Average total assets Profitability can be improved by increasing profit margin, asset turnover, or both. Copyright © by Houghton Mifflin Company. All rights reserved.

Evaluation of Profitability and Liquidity: Debt to Equity
Profitability measure: The more debt, the more profit must be earned to pay interest. Liquidity measure: how much debt needs to be paid. Proportion of company financed by creditors compared to the amount financed by investors. Total liabilities $60,483 Stockholders’ equity $98,433 = .614 = Copyright © by Houghton Mifflin Company. All rights reserved.

Average Debt to Equity for Selected Industries

Evaluation of Profitability: Return on Equity
Measure of how much owners have earned on their investment. Net income $17,881 Average Stockholders’ Equity $99,493 = = .180 Copyright © by Houghton Mifflin Company. All rights reserved.

Average Return on Equity for Selected Industries

Graphical Presentation of Dell Computer Corp.’s Profitability Ratios

Discussion Q. Which is the more important goal, liquidity or profitability? Explain your answer. A. The goals of liquidity and profitability are equally important. Both must be met if a business is to survive. Copyright © by Houghton Mifflin Company. All rights reserved.

OK, LET’S REVIEW . . . State the objectives of financial reporting. State the qualitative characteristics of accounting information and describe their interrelationships. Define and describe the use of the conventions of comparability and consistency, materiality, conservatism, full disclosure, and cost-benefit. Copyright © by Houghton Mifflin Company. All rights reserved.

CONTINUING OUR REVIEW . . . Explain management’s responsibility for ethical financial reporting and define fraudulent financial reporting. Identify and describe the basic components of a classified balance sheet. Copyright © by Houghton Mifflin Company. All rights reserved.

AND FINALLY . . . Prepare multi-step and single-step classified income statements. Evaluate liquidity and profitability using classified financial statements. Copyright © by Houghton Mifflin Company. All rights reserved.

Financial & Managerial Accounting 2002e

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