Financial Reporting and Analysis

Financial Reporting and Analysis
Chapter 4 Financial Reporting and Analysis Copyright © Cengage Learning. All rights reserved.

Foundations of Financial Accounting
Objective 1 Describe the objectives of financial reporting and identify the qualitative characteristics, conventions, and ethical considerations of accounting information. Copyright © Cengage Learning. All rights reserved.

Objectives of Financial Reporting
To provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. ================================== Information that is decision-useful to capital providers may also be useful to other users of financial reporting who are not capital providers. Copyright © Cengage Learning. All rights reserved.

Objectives of Financial Reporting
To be useful for decision making, information about financial reporting, which includes financial statements but is not limited to them, must be able to: Assess cash flow prospects. Capital providers and other users need information to help make judgments about the entity’s ability to general cash flows. Assess stewardship. Capital providers and others need information about the entity’s resources (assets), claims against them (liabilities and stockholders’ equity) and changes in these resources and claims as impacted by transactions (earnings and cash flows) and other economic events. Copyright © Cengage Learning. All rights reserved.

Financial Statements Balance sheet Income statement
Statement of retained earnings Statement of cash flows These are important output of the accounting system, but not the only output. Management’s explanations and other information, including underlying assumptions and significant uncertainties about methods and estimates used in the financial reports, constitute important components of financial reporting by an entity. Copyright © Cengage Learning. All rights reserved.

Financial Statements (cont’d)
Because of a potential conflict of interest between managers, who prepare the statements, and investors or creditors, who invest in or lend money to the business, financial statements are audited by outside accountants to ensure their reliability. Copyright © Cengage Learning. All rights reserved.

Qualitative Characteristics
In practice, accounting information… Is neither simple nor precise Rarely satisfies all criteria Often results from approximate measures Based on rules and conventions rather than exact amounts Copyright © Cengage Learning. All rights reserved.

Qualitative Characteristics
The goal of generating accounting information is to provide data to different users for different needs. How this goal is achieved provides interest and controversy in accounting. To facilitate interpretation, the FASB has developed qualitative characteristics of accounting information. The most important or fundamental qualitative characteristics are relevance and faithful representation. Copyright © Cengage Learning. All rights reserved.

Relevance Relevance means that the information has a direct bearing on a decision. To be relevant, information must have: Predictive value, Confirmative value, or Both. Predictive value means that it will help capital provider decisions about the future. Confirmative value means that it will provide information to determine if expectations have been met. Copyright © Cengage Learning. All rights reserved.

Faithful Representation
Faithful representation means that the financial reporting must be a reliable depiction of what an entity purports to represent. To be faithful, information must be Complete (or all necessary information needed for a reliable decision), Neutral (or free from bias), and Free from material error (or meets a minimum level of accuracy, without distorting what the information depicts). Copyright © Cengage Learning. All rights reserved.

Qualitative Characteristics that Complement Information Quality
Comparability: The quality that enables users to identify similarities and differences between two sets of economic phenomena. Verifiability: The quality that helps assure users that information faithfully represents what it purports to depict. Timeliness: The quality that enables the user to receive information in time to influence a decision. Understandability: The quality that enables users to comprehend the meaning of the information they receive. Copyright © Cengage Learning. All rights reserved.

Accounting Conventions
Objective 2 Define and describe the conventions of consistency, full disclosure, materiality, conservatism, and cost-benefit. Copyright © Cengage Learning. All rights reserved.

Accounting Conventions
Since financial statement are based largely on estimates, the application of accounting rules for recognition and allocation are critical. To deal with these constraints, five conventions help in the preparation and interpretation of financial statements. They are: Consistency, Materiality, Conservatism, Full Disclosure, and Cost-Benefit. Copyright © Cengage Learning. All rights reserved.

Consistency Means constantly applying policies or principles
Once an accounting procedure is adopted by a company, it must remain in use from one period to another, unless users are informed of a change. Users can assume that no arbitrary changes in accounting measures and procedures have taken place when interpreting financial statements. Copyright © Cengage Learning. All rights reserved.

Consistency (cont’d) Changes in accounting measures and procedures may become necessary. Example: A method of accounting for inventory may be changed because it is believed that the new method improves the matching of revenues and costs. Generally accepted accounting principles require that changes and their dollar effects be described in the notes to the financial statements. Copyright © Cengage Learning. All rights reserved.

Full Disclosure Requires that financial statements and their notes present all information relevant to users Financial statements should offer explanations needed to keep them from being misleading Many disclosures are required by the SEC and other official bodies Other disclosures are based the judgment of management and the company accountants If too much information is disclosed, the notes impede rather than help understanding Copyright © Cengage Learning. All rights reserved.

Examples of Required Disclosures
Changes of accounting practices Amount of depreciation expense on income statement Amount of accumulated depreciation on the balance sheet Accounting procedures used in preparing financial statements Important terms of the company’s debt Commitments and contingencies Important events taking place after the date of the statements Copyright © Cengage Learning. All rights reserved.

Materiality Refers to the importance of an item or event
If an item is relevant to the decisions a user of financial statements makes, it is material Is normally determined by relating an item’s dollar value to an element of the financial statements Some accountants believe an item that is 5% or more of net income is relevant Depends on the nature of the item The discovery of a bribe or theft, no matter what the amount involved, is considered material Copyright © Cengage Learning. All rights reserved.

Conservatism Means that when there is uncertainty about which accounting procedure to use, the one that is least likely to overstate assets and income should be used Should be used only when uncertainty exists If used incorrectly, leads to incorrect and misleading financial statements A common application is use of the lower-of-cost-or-market method of accounting for inventories If market value > cost, use cost If market value < cost, use market value Copyright © Cengage Learning. All rights reserved.

Cost-Benefit Holds that the benefits of providing accounting information should exceed the costs of providing it Information must meet minimum levels of reliance and reliability to be useful Beyond that, the FASB and SEC, who require information, and the accountant, who provides information, must judge the costs and benefits in each case Copyright © Cengage Learning. All rights reserved.

Costs and Benefits Costs Benefits
Fall at first on the preparers of financial statements Ultimately are passed on to society in the form of prices Benefits Reaped by both the preparers and users of financial statements Ultimately are passed on to society in the form of social benefits from more efficient allocation of resources Copyright © Cengage Learning. All rights reserved.

Classified Balance Sheet
Objective 3 Identify and describe the basic components of a classified balance sheet. Copyright © Cengage Learning. All rights reserved.

Classified Balance Sheet
Assets, liabilities, and stockholders’ equity sections are subdivided into useful categories. Most companies use similar subdivisions, but subdivisions usually depend upon the type of business Copyright © Cengage Learning. All rights reserved.

Current Assets Cash and other assets that are reasonably expected to be converted to cash, sold, or consumed within one year Or within the normal operating cycle of the business, whichever is longer Copyright © Cengage Learning. All rights reserved.

Normal Operating Cycle
The average time needed to go from cash to cash Spend cash to buy merchandise inventory Sell inventory on account Collect cash The normal operating cycle is usually less than one year Copyright © Cengage Learning. All rights reserved.

Examples of Current Assets
Cash Temporary investments Accounts receivable Inventory Prepaid expenses Copyright © Cengage Learning. All rights reserved.

Investments Assets Usually long-term,
Not used in the normal operation of the business Management does not plan to convert to cash within the next year Copyright © Cengage Learning. All rights reserved.

Types of Investments Securities held for investment
Long-term notes receivable Land held for future use Plant or equipment not used in the business Special funds established to Pay off debt Purchase a building Large permanent investments in another company For the purpose of controlling that company Copyright © Cengage Learning. All rights reserved.

Property, Plant, and Equipment
Includes long-term asset used in the continuing operation of the business. These assets represent a place to operate (land and buildings) Equipment to produce, sell, deliver, and service the company’s goods Copyright © Cengage Learning. All rights reserved.

Property, Plant, and Equipment
Also called Operating assets Fixed assets Tangible assets Long-lived assets Plant assets The costs of these assets are depreciated Spread over the periods they benefit Past depreciation is recorded in the Accumulated Depreciation accounts Copyright © Cengage Learning. All rights reserved.

Intangible Assets Long-term assets that have no physical substance
But have a value based on rights or privileges that belong to their owner. These assets are recorded at cost. The cost is spread over the expected life of the right or privilege. Copyright © Cengage Learning. All rights reserved.

Examples of Intangible Assets
Patents Copyrights Goodwill Franchises Trademarks Copyright © Cengage Learning. All rights reserved.

Liabilities Divided into two categories based on when they fall due
Current liabilities Long-term liabilities Copyright © Cengage Learning. All rights reserved.

Current Liabilities Obligations that must be satisfied within one year or within the normal operating cycle, whichever is longer Typically paid from current assets or by incurring new short-term liabilities Examples: Notes payable, accounts payable, current portion of long-term debt, salaries and wages payable, taxes payable, customer advances (unearned revenues) Copyright © Cengage Learning. All rights reserved.

Long-Term Liabilities
Debts of the business that fall due more than one year in the future or beyond the normal operating cycle, which will be paid out of noncurrent assets Examples: Mortgages payable, long-term notes, bonds payable, employee pension obligations, and long-term lease liabilities Copyright © Cengage Learning. All rights reserved.

Deferred Income Taxes Are often disclosed as a separate category in the long-term liability section of the balance sheet of publicly held corporations Are the result of different rules that apply for measuring income taxes for tax purposes and for financial reporting purposes Amount is the cumulative annual difference between income taxes payable to governments and income tax expense reported on the income statement Copyright © Cengage Learning. All rights reserved.

Stockholders’ Equity Made up of two components on the balance sheet:
Contributed or paid-in capital Retained Earnings Generally, contributed capital is shown as two amounts: Par value of the issued stock Amounts paid in, or contributed, in excess of the par value per share Copyright © Cengage Learning. All rights reserved.

Forms of the Income Statement
Objective 4 Describe the features of multistep and single-step classified income statements. Copyright © Cengage Learning. All rights reserved.

Multistep Income Statements
Presented in a series of steps, or subtotals, to arrive at net income Notice that the multistep income statement for a service company and a merchandising or manufacturing company both include three of the same steps. Copyright © Cengage Learning. All rights reserved.

Multistep Income Statements
Merchandising companies buy and sell products Manufacturing companies make and sell products Both require an additional step in the multistep income statement for the cost of the goods that are sold Service companies only have operating costs – they do not sell a physical product Gross Margin = Net Sales – Cost of Goods Sold Copyright © Cengage Learning. All rights reserved.

Components of Multistep Income Statements for Service and Merchandising or Manufacturing Companies
Copyright © Cengage Learning. All rights reserved.

Net Sales Gross sales equal the total cash sales and total credit sales during a given accounting period Follows the revenue recognition rule Revenue is recognized even though cash may not be collected until the following accounting period Amount of sales and trends in net sales over time are used to analyze a company’s progress Copyright © Cengage Learning. All rights reserved.

Cost of Goods Sold The amount paid for merchandise sold, or the cost to manufacture products that were sold, during an accounting period Also called cost of sales Copyright © Cengage Learning. All rights reserved.

Gross Margin Difference between net sales and cost of goods sold
Management is interested in both the Amount of gross margin Percentage of gross margin Both are useful in planning business operations Copyright © Cengage Learning. All rights reserved.

Operating Expenses Expenses, other than cost of goods sold, that are incurred in running a business These expenses are grouped into categories Selling expenses General and administrative expenses Other revenues and expenses Copyright © Cengage Learning. All rights reserved.

Types of Selling Expenses
Cost of storing goods Cost of preparing goods for sale Advertising and promoting sales Delivering goods to the buyer Called freight out expense General occupancy expenses (may be allocated among selling expenses and general and administrative expenses) Rent expense Utilities expense Insurance expense Copyright © Cengage Learning. All rights reserved.

General and Administrative Costs
General office expenses Accounting Personnel Credit and collections Expenses that apply to overall operations General occupancy expenses (may be allocated among general and administrative expenses and selling expenses) Rent expense Utilities expense Insurance expense Copyright © Cengage Learning. All rights reserved.

Income from Operations
Difference between gross margin and operating expenses Also called operating income Represents income from a company’s main business Copyright © Houghton Mifflin Company. All rights reserved. Copyright © Cengage Learning. All rights reserved.

Other Revenues and Expenses
Not part of a company’s operating activities Includes Revenues or expenses from investments Dividends and interest Interest and other expenses from borrowing Any other revenue or expense not related to the company’s normal business operations Copyright © Cengage Learning. All rights reserved.

Income Before Income Taxes
The amount a company has earned from all activities – operating and nonoperating – before taxes Copyright © Cengage Learning. All rights reserved.

Net Income Amount that remains of the gross margin after operating expenses are deducted, other revenues and expenses are added or deducted, and income taxes are deducted It is the final figure, or “bottom line,” of the income statement Copyright © Cengage Learning. All rights reserved.

Net Income (cont’d) Is an important performance measure
Represents the amount of business earnings that accrue to stockholders Is the amount transferred to retained earnings from all income generating activities during the year Often used to determine whether a business has been operating successfully Copyright © Cengage Learning. All rights reserved.

Performance measure shown on the
Earnings per Share Performance measure shown on the income statement Useful in assessing a company’s Profit earning success Earnings in relation to the market price of its stock Copyright © Cengage Learning. All rights reserved.

Single-Step Income Statement
A condensed income statement that arrives at net income in a single step First section includes major categories of revenues Second section includes major categories of expenses Total Revenues – Total Expenses = Income Before Income Taxes Copyright © Cengage Learning. All rights reserved.

Using Classified Financial Statements
Information in financial statements may be used to evaluate two important goals of management Maintaining adequate liquidity Achieving satisfactory profitability Copyright © Cengage Learning. All rights reserved.

Evaluation of Liquidity
Liquidity means having enough money on hand to pay bills when they become due and to cover unexpected needs for cash Two measures of liquidity: Working capital Current ratio Copyright © Cengage Learning. All rights reserved.

Working Capital The amount by which total current assets exceed total current liabilities Current assets. Assets that will be converted to cash or used up within one year or one operating cycle, whichever is longer Current liabilities. Debts that must be paid or obligations that must be performed within one year or one operating cycle, whichever is longer Copyright © Cengage Learning. All rights reserved.

Working Capital (cont’d)
Working capital is used to buy inventory, obtain credit, and finance expanded sales. Lack of working capital can lead to a company's failure. Working capital for Cruz Corporation: Copyright © Cengage Learning. All rights reserved.

The ratio of current assets to current liabilities
Current Ratio The ratio of current assets to current liabilities Is closely related to working capital Believed by many to be a good indicator of a company’s ability to Pay its bills Repay outstanding debt Copyright © Cengage Learning. All rights reserved.

Evaluation of Profitability
Profitability means the ability to earn a satisfactory income. Common profitability measures: Profit margin Asset turnover Return on assets Debt to equity ratio Return on equity Copyright © Cengage Learning. All rights reserved.

Shows the percentage of each sales dollar that results in net income.
Profit Margin Shows the percentage of each sales dollar that results in net income. Profit margin for Cruz Corporation: This means that on each dollar of net sales, Cruz Corporation made 4.6 cents. Copyright © Cengage Learning. All rights reserved.

Measures how efficiently assets are used to produce sales
Asset Turnover Measures how efficiently assets are used to produce sales Shows a meaningful relationship between an income statement figure and a balance sheet figure Shows how many dollars of sales were generated by each dollar of assets A high asset turnover means a company uses its assets productively Copyright © Cengage Learning. All rights reserved.

Asset Turnover (cont’d)
Asset turnover for Cruz Corporation: Average total assets is computed by adding total assets at the beginning of the year to total assets at the end of the year and dividing by 2. This means that Cruz produces $2.00 in sales for each $1.00 invested in average total assets Copyright © Cengage Learning. All rights reserved.

Measures how efficiently a company uses its assets to produce income
Return on Assets Measures how efficiently a company uses its assets to produce income Copyright © Cengage Learning. All rights reserved.

Return on Assets (cont’d)
Combines profit margin and asset turnover Indicates income-generating strength of a firm’s resources Indicates how efficiently the company is using all its assets Return on assets overcomes the limitations of profit margin and asset turnover ratios Profit margin does not consider the assets necessary to produce income Asset turnover ratio does not take into account the amount of net income produced Copyright © Cengage Learning. All rights reserved.

Return on Assets (cont’d)
Return on assets for Cruz Corporation: This means that for each dollar invested by stockholders, Cruz’s assets generate 9.4 cents of net income *Difference due to rounding Copyright © Cengage Learning. All rights reserved.

Debt to Equity Ratio Shows the proportion of the company’s assets that is financed by creditors in comparison to that financed by stockholders A company with a high debt to equity ratio is at risk in poor economic times because it must continue to repay creditors A company with a low debt to equity ratio is safer because stockholders do not have to be repaid and dividends can be deferred Copyright © Cengage Learning. All rights reserved.

Debt to Equity (cont’d)
The assets of a company are financed by: Creditors (creating liabilities) Investors (creating stockholders’ equity) A debt to equity ratio of 1.0 means that half the company’s assets are financed by creditors and half are financed by investors. Represent assets financed by creditors Represent assets financed by investors Copyright © Cengage Learning. All rights reserved.

Return on Equity Measures how much income was earned on each dollar invested by stockholders Acceptability of a company’s return on equity ratio depends on how much The company earned in prior years Other companies in the same industry earned Copyright © Cengage Learning. All rights reserved.

Return on Equity (cont’d)
Return on equity for Cruz Corporation: Average stockholders’ equity is computed by adding total stockholders’ equity at the beginning of the year to total stockholders’ equity at the end of the year and dividing by 2. This means that Cruz earned 14.6 cents for every dollar invested by stockholders Copyright © Cengage Learning. All rights reserved.

Stop & Review 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 company is to survive. Copyright © Cengage Learning. All rights reserved.

Chapter Review Describe the objectives of financial reporting and identify the qualitative characteristics, conventions, and ethical considerations of accounting information. Define and describe the conventions of consistency, full disclosure, materiality, conservatism, and cost-benefit. Identify and describe the basic components of a classified balance sheet. Copyright © Cengage Learning. All rights reserved.

Chapter Review (cont’d)
Describe the features of multistep and single-step classified income statements. Use classified financial statements to evaluate liquidity and profitability. Copyright © Cengage Learning. All rights reserved.

Financial Reporting and Analysis

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