Chapter 2

A Further Look at Financial Statements After studying Chapter 2, you should be able to:
Explain the meaning of generally accepted accounting principles and describe the basic objective of financial reporting. Discuss the qualitative characteristics of accounting information. Identify two constraints in accounting. Identify the sections of a classified balance sheet.
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Chapter 2

A Further Look at Financial Statements

Identify and compute ratios for analyzing a company's profitability. Explain the relationship between a retained earnings statement and a statement of stockholders' equity. Identify and compute ratios for analyzing a company's liquidity and solvency using a balance sheet. Identify and compute ratios for analyzing a companys liquidity and solvency using a statement of cash flows.

Chapter 2

General Guide for Financial Accounting

Generally Accepted Accounting Principles

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What is financial accounting supposed to accomplish?

Provide the the most useful financial information for

Decision Making
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Primary Accounting Setting Body in the U.S.

Financial Accounting Standards Board

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U.S. Government Agency That Oversees Financial Markets

Securities Exchange Commission

Remember
GAAP Are the Rules The FASB makes the rules. The SEC enforces the rules.

Basic Terms
Relevance - information makes a difference in decisions Reliability - information must be free of error and bias Comparability - ability to compare information of different companies because they use the same accounting principles Consistency - use of same accounting principles and methods from year to year 9 within the same company

Relevance
1. Provides a basis for forecasts 2.Confirms/corrects prior expectations

Reliability 1. Is verifiable 2. Is a faithful representation 3. Is neutral

Comparability Different companies use similar accounting PRINCIPLES

Consistency Company uses same accounting METHODS from year to year

3. Is timely

Characteristics of Useful Information

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Constraints in Accounting
Permits companies to apply GAAP without hurting the usefulness of information
Materiality - The constraint of determining whether an item is large enough to likely influence a decision. Conservatism - The approach of choosing an accounting method, when in doubt, that will be least likely to overstate assets and net income.

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A 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

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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. Examples: Cash Short-term investments Receivables Inventories Supplies Prepaid expenses 13

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. Example: Investments of stocks and bonds of other corporations. Investments in long-term assets such as land or buildings that are not currently being used in the companys operating activities.

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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 15

Depreciation is...
Practice of allocating an assets full purchase price to a number of years instead of expensing full cost in year of purchase.

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Accumulated Depreciation...
Shows the total amount of depreciation taken over the life of the asset.

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CSU CORPORATION Assets That A Company Balance Sheet Depreciates... December 31, 2004

Should be shown at cost less accumulated depreciation

Assets Cash Accounts receivable Supplies Equipment Less: Accumulated Depreciation Total assets $ 2,000 4,000 1,800

24,000 8,000

16,000 $23,800
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Intangible Assets
Noncurrent assets Have no physical substance Examples: patents copyrights trademarks or trade names franchise

Intangible Assets have value because of the exclusive rights or privileges they possess.

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

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

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

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Stockholders' Equity
Capital stock - investments in the business by the stockholders Retained earnings - earnings kept for use in the business

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HUMANA CORPORATION
Balance Sheet December 31, 200X (in millions)

Assets Current Assets Cash Marketable securities (current) Receivables Other current assets Total current assets Property and equipment (net) Marketable securities (long-term) Other long-term assets Total Assets Liabilities and Stockholders Equity Liabilities Current Liabilities Medical costs payable Accounts payable Income taxes payable Total current liabilities Long-term debt Total liabilities Stockholders equity Common stock Retained earnings Total Liabilities and stockholders equity

Current

272 609 74 83 1,038 317 322 280 $1,957

Current

527 233 56 816 83 899 830 228 $1,957

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Ratio Analysis...
Expresses relationship among selected items of financial statement data Relationship can be expressed in term of
percentage rate proportion
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Ratio Analysis Classifications...

Liquidity Ratios - measures of short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash Profitability Ratios - Measures of the income or operating success of a company for a given period of time Solvency Ratios - Measures of the ability of the company to survive over a long period of time

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Ratio Analysis
Intracompany comparisons - covering two years of the same company Industry average comparisons - based on average ratios for a particular industry Intercompany comparisons - based on comparisons with a competitor in the same industry

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Profitability Ratios...
Measures of the income or operating success of a company for a given period of time

Two Examples

Earnings Per Share Price-Earnings Ratio

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Earnings Per Share

How does the companys earning performance compare with that of previous years?
EPS= Net income-Preferred stock dividends Average common shares outstanding

Higher value = improved performance

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Price-Earnings Ratio
Stock price per share Price-Earnings Ratio = Earnings per share

How does the market perceive the companys prospect for future earnings?
High ratio suggests market has favorable expectations
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Statement of Retained Earnings

Describes the events that caused changes in the retained earnings account for the period.

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Retained Earnings Statement For the Year Ended December 31, 200X

CSU CORPORATION

Retained earnings, January 1 Add: Net Income Less: Dividends Retained earnings, December 31

0 6,800 6,800 0 $ 6,800

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Statement of Retained Earnings and Statement of Stockholders Equity

Stockholders Equity:
Retained Earning Common Stock
Since both of these parts affect stockholders equity a statement of stockholders equity provides better information than a statement of retained earnings.
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Financial Ratio Classifications

Liquidity Ratios - measures of shortterm ability of the company to pay its maturing obligations and to meet unexpected needs for cash Profitability Ratios -measures of the income or operating success of a company for a given period of time Solvency Ratios - measures of the ability of a company to survive over a long period of time 33

Liquidity Ratios

Working capital Current ratio

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Working Capital
Measures short-term ability to pay liabilities
Current Assets - Current Liabilities = Working Capital

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Current Ratio
Measure of short - term ability to pay obligations
Current Ratio =

Current Assets Current Liabilities

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Solvency Ratio
Debt to Total Assets Ratio measures % of assets financed by creditors.
Total Debts Debt to Total Asset Ratio = Total Assets

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Purpose of Statement Of Cash Flows To provide information about cash receipts cash payments net changes in cash

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Changes Result From

Operating activities Financing activities Investing activities

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Operating Activities
Cash inflows and cash outflows associated with the primary operations of the business.
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Financing Activities
Cash inflows/ outflows come from sources funding the business Sale of Stock/ Payment of Dividends Issuing Debt/Repaying Debt

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Investing Activities
Cash inflows/ outflows result from changes in investments and longterm assets purchasing/disposing of investments and long-lived assets using cash lending money and collecting the loans

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Current Cash Debt Coverage Ratio

= Cash Provided by Operating Activities Average Current Liabilities

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Cash Debt Coverage Ratio

= Cash Provided by Operating Activities Average Total Liabilities

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