1. Financial Accounting: Tools for Business Decision Making Prepared by: Dr. Jessica J. Frazier and Philip Li Eastern Kentucky University Kimmel, Weygandt, Kieso

2. CHAPTER 2 A Further Look at Financial Statements After reading Chapter 2, you should be able to: zExplain the meaning of generally accepted accounting principles and describe the basic objective of financial reporting. zDiscuss the qualitative characteristics of accounting information. zIdentify two constraints in accounting. zDistinguish between a single-step and a multiple-step income statement.

3. CHAPTER 2 A Further Look at Financial Statements After reading Chapter 2, you should be able to: zIdentify and compute ratios for analyzing a company's profitability. zExplain the relationship between a retained earnings statement and a statement of stockholders' equity. zIdentify sections of a classified balance sheet. zIdentify and compute ratios for analyzing a company's liquidity and solvency. zIdentify the sections of the statement of cash flows and the purpose of each.

4. THE MEANING OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES zGenerally Accepted Accounting Principles (GAAP) are the agreed-upon accounting rules which most U. S. companies use in preparing financial statements. GAAP are promulgated by the Financial Accounting Standards Board.

5. THE BASIC OBJECTIVE OF FINANCIAL REPORTING zThe basic objective for financial reporting is to provide information useful for decision making.

6. THE QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION zRelevance zReliability zComparability and Consistency

7. Relevance zIf information has the ability to make a difference in a decision scenario, it is relevant. zAccounting information is also relevant to business decisions because it confirms or corrects prior expectations. zFinancial statements help predict future events and confirm or correct prior expectations about the financial health of the company. In order to be relevant accounting information must be timely.

8. Reliability zInformation is reliable if it can be depended on. To be reliable information must be: yVerifiable--free from error and bias, yFaithful representative--factual, and yNeutral--cannot be selected, prepared, or presented to favor one set of users over another.

9. Comparability and Consistency zComparability--when different firms use the same accounting principles. zConsistency--when firms use the same accounting principles and methods from year to year.

10. THE TWO CONSTRAINTS IN ACCOUNTING zMateriality zConservatism

11. Materiality zAn item is material if it can influence the decision of an investor or a creditor. zAn item is immaterial if inclusion has no impact on the decision.

12. Conservatism zAllows the accountant to choose the accounting method that will be the least likely to overstate assets and income. zMany times items in inventory become obsolete or damaged. In this instance inventory items should be listed at market value if it is lower than cost.

13. TWO FORMS OF INCOME STATEMENTS zSingle-step income statement zMultiple-step income statement

14. Single-Step Income Statement zOne step is required in determining net income--subtract total expenses from total revenues. yRevenues - includes both operating revenues and other revenues and gains. yExpenses - includes cost of goods sold, operating expenses, as well as other expenses and losses.

15. Multiple-Step Income Statement zHighlights the components of net income. zDistinguishes between operating and nonoperating activities. zGross profit--merchandising profit--is determined by subtracting cost of goods sold from sales revenue.

16. Multiple-Step Income Statement zOperating expenses - are subtracted from gross profit in order to determine income from operations Operating expenses include- ySelling expenses--all of the expenses associated with selling the merchandise from the solicitation of the sale until the product is in the hands of the buyer. yAdministrative expenses--general expenses relating to general operating activities, human resources, accounting, clerical, security, etc.

17. Multiple-Step Income Statement zNonoperating activities--unrelated to the company's primary line of operations. zOther revenues and gains--Interest, dividend, rent revenue, and gain from sale of property. zOther expenses and losses--Interest expense; casualty losses; loss from sale or abandonment of property, plant, and equipment; and loss from strikes by employees and suppliers.

18. RATIOS ANALZSIS OF PROFITABILITY zProfitability ratios - measure the income or operating success of an enterprise for a given period of time. yReturn on assets ratio yProfit margin ratio

19. Return On Assets Ratio zOverall measure of profitability. zComputed by dividing net income by average assets. zReveals the amount of net income generated by each dollar invested.

20. Profit Margin Ratio zMeasures the percentage of each dollar of sales that results in net income. zComputed by dividing net income by net sales for the period.

21. STATEMENT OF RETAINED EARNINGS AND STATEMENT OF STOCKHOLDERS’ EQUITY zStatement of Retained Earnings yDescribes the events that caused changes in the retained earnings account for the period. yAdd net income and subtract dividends from beginning balance of retained earnings to arrive at ending balance of retained earnings. yStatement of Stockholders' Equity yReports all changes in stockholders' equity accounts (i.e. capital stock issued or retired).

22. A CLASSIFIED BALANCE SHEET zA classified balance sheet generally contains the following standard classifications: yCurrent Assets yLong Term Investments yProperty, Plant, and Equipment yIntangible Assets yCurrent Liabilities yLong-Term Liabilities yStockholders' Equity

23. Current Assets zAssets that are expected to be converted to cash or used in the business within a short period of time, usually one year. zExamples of current assets include: cash, marketable securities, receivables, inventories and prepaid expenses. zOn the balance sheet, current assets are listed in order of liquidity.

24. Long Term Investments zAssets that can be converted into cash, but whose conversion is not expected within one year. zAssets not intended for use within the business. zExamples are investments of stocks and bonds of other corporations.

25. Property, Plant, and Equipment zAssets with relatively long useful lives. zAssets used in the business. zExamples include land, buildings, machinery, delivery equipment, and furniture and fixtures.

26. Intangible Assets zNon current assets. zAssets which have no physical substance. zExamples are patents, copyrights, and trademarks or trade names.

27. Current Liabilities zObligations that are supposed to be paid within the coming year. zCommon examples are accounts payable, wages payable, bank loans payable, interest payable, taxes payable, and current maturities of long-term bank loans payable, interest payable, and current maturities of long-term obligations.

28. Long-Term Liabilities zObligations expected to be paid after one year. zLiabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and obligations under employee pension plans.

29. Stockholders' Equity zCapital Stock - investments in the business by the stockholders. zRetained earnings - earnings retained for use in the business.

30. LIQUIDITY AND SOLVENCY zLiquidity - The ability to pay obligations as they come due. zSolvency - The ability of the enterprise to survive over a long period of time.

31. Ratios Analyses of Liquidity zWorking capital zCurrent ratio

32. Working Capital zMeasure of short term ability to pay obligations. zExcess of current assets over current liabilities. zPositive working capital indicates the likelihood for paying liabilities is favorable.

33. Current Ratio zMeasure of short term ability to pay obligations. zComputed by dividing current assets by current liabilities. zMore dependable indicator of liquidity than working capital. zDoes not take into account composition of current assets.

34. Ratios Analyses of Solvency zDebt to Total Assets Ratio

35. Debt to Total Assets Ratio zMeasures the percentage of assets financed by creditors. zThe higher the percentage of debt financing, the riskier the business. zComputed by dividing total debt (both current and long-term liabilities) by total assets.

36. SECTIONS OF STATEMENT OF CASH FLOWS zFinancing activities zInvesting activities zOperating activities

37. Financing Activities zCash inflows from sources funding the business (i. e. sale of stock, sale of bonds, borrowings, etc.).

38. Investing Activities zCash outflows associated with purchasing resources needed in operating the business.

39. Operating Activities zCash inflows and cash outflows associated with the primary operations of the business.

40. Chapter 2 Review zWhat are generally accepted accounting principles? Name the standard setting body that promulgates these principles. What is the basic objective of financial reporting? zName and explain the significance of the qualitative characteristics of accounting information. zWhat are the two constraints in accounting? Why are they important?

41. Chapter 2 Review zWhat are the differences between a single-step and a multiple-step income statement? zName two profitability ratios. How are these ratios computed? How are the results interpreted? zWhat is the relationship between a retained earnings statement and a statement of stockholders' equity? Which contains the most information? zIdentify sections of a classified balance sheet.

42. Chapter 2 Review zCompute ratios for analyzing a firm's liquidity and solvency. zHow are these ratios interpreted? zIdentify the sections of the statement of cash flows and the purpose of each.

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