Principles of financial accounting 12e by needles crosson chapter 05

 LO2 : Identify and define the basic components of financial reporting, and prepare a classified balance sheet  LO3 : Use classified financial statements to evaluate liquidity and pro

Classified Balance Sheet

5

C H A P T E R

 LO2 : Identify and define the basic

components of financial reporting, and prepare a classified balance sheet

 LO3 : Use classified financial statements

to evaluate liquidity and profitability.

SECTION 1: CONCEPTS

(slide 1 of 3)

 Relevance : information has a direct bearing on a decision

– Predictive value : information helps capital providers make decisions about future actions

– Confirmative value : information confirms or changes

previous evaluations – Materiality : the omission or misstatement of information

could influence the user’s economic decisions taken on the basis of the financial statements

 Faithful representation : information is complete,

neutral, and free from material error

– Completeness : all information necessary for a reliable

decision is provided – Neutrality : information is free from bias intended to achieve

a certain result or bring about a particular behavior – Free from material error : information meets a minimum

level of accuracy so it does not distort what is being reported

SECTION 1: CONCEPTS

(slide 2 of 3)

 Enhancing qualitative characteristics

– Comparability : the quality that enables users to

identify similarities and differences between two sets of financial data

– Verifiability : the quality that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation

– Timeliness : the quality that enables users to receive

information in time to influence their decisions – Understandability : the quality that enables users to comprehend the meaning of information

– Cost constraint ( cost-benefit ): the benefits to be

gained from providing accounting information should be greater than the costs of providing it

SECTION 1: CONCEPTS

(slide 3 of 3)

 Accounting conventions : constraints used

in preparing financial statements

– Consistency : once a company has adopted an

accounting procedure, it must use it from one period

to the next unless a note to the financial statements informs users of a change

– Full disclosure (transparency): financial

statements must present all the information relevant

to users’ understanding of the statements – Conservatism : when faced with choosing between two equally acceptable procedures or estimates, accountants should choose the one that is least likely to overstate assets and income

Objective of Financial Reporting

reporting must enable the user to

– Assess cash flow prospects

– Assess management’s stewardship

 Financial reporting includes the financial

statements (balance sheet, income statement, statement of owner’s equity, and statement of cash flows) that are prepared periodically.

– Management’s underlying assumptions and methods and estimates used in the

financial statements are also important components of financial reporting.

(slide 1 of 2)

 Relevance means that the information

has a direct bearing on a decision In

other words, if the information were not

available, a different decision would be

made

– To be relevant, information must have one or both of the following:

 Predictive value—Information has predictive value

if it helps capital providers make decisions about future actions.

 Confirmative value—Information has confirmative value if it confirms or changes previous evaluations.

(slide 2 of 2)

 Relevant information is also subject to materiality.

– Information is material if its omission or

misstatement could influence the user’s economic decisions taken on the basis of the specific entity’s financial statements.

– Materiality is related to both the nature of an item and its size or misstatement.

 The materiality of an item normally is determined by relating its dollar value to an element of the financial statements, such as net income or total assets.

 As a rule, when an item is worth 5 percent or more of net income, accountants treat it as material.

 However, many small errors can add up to a material amount.

Faithful Representation

 Faithful representation means that

the financial information is complete,

neutral, and free from material errors.

– Complete information provides all

information necessary for a reliable decision – Neutral information is free from bias

intended to achieve a certain result or to bring about a particular behavior.

– To be free from material error means

information meets a minimum level of accuracy so it does not distort what is being reported.

Enhancing Qualitative Characteristics

(slide 1 of 2)

 Other characteristics that the FASB has established for interpreting accounting information include:

– Comparability —enables users to identify

similarities and differences between two sets of financial data.

– Verifiability —different knowledgeable and

independent observers could reach consensus that a particular depiction is a faithful

representation.

– Timeliness —enables users to receive

information in time to influence their decisions – Understandability —enables users to

comprehend the meaning of the information.

Enhancing Qualitative Characteristics

(slide 2 of 2)

 These enhancing characteristics are subject

to the cost constraint (or cost-benefit ),

which holds that the benefits to be gained

from providing accounting information

should be greater than the costs of providing it.

– Minimum levels of relevance and faithful

representation must be reached if accounting information is to be useful.

– Beyond the minimum levels, it is up to the FASB, the SEC, and the accountant who provides the information to judge the costs and benefits in each case.

Accounting Conventions

(slide 1 of 2)

 Accounting conventions , or constraints, used in

preparing financial statements include:

– Consistency —requires that once a company has adopted an accounting procedure, it must use it from one period to the next unless a note to the financial statements informs users of a change.

– Full disclosure (or transparency)—requires that financial statements present all the information relevant to users’ understanding of the

Accounting Conventions

(slide 2 of 2)

– Conservatism —holds that, when faced

with choosing between two equally acceptable procedures or estimates, the accountant should choose the one that is least likely to overstate assets and

income.

 Conservatism can be a useful tool, but if abused, can lead to incorrect or misleading financial statements.

 Accountants should apply the conservatism convention only when they are uncertain about which accounting procedure or estimate to

use.

Ethical Financial Reporting

 Under the Sarbanes-Oxley Act, chief

executive officers and chief financial

officers of all publicly traded companies must certify that, to their knowledge,

their quarterly and annual statements

are accurate and complete.

 Fraudulent financial reporting can have high costs for investors, lenders,

employees, and customers—as well as

for the people who condone, authorize,

or prepare misleading reports.

Classified Balance Sheet

that are divided into subcategories are called

classified financial statements

liabilities, and owner’s equity are broken down are shown below.

 The classified balance sheet typically divides assets into four categories: current assets; investments; property, plant, and

equipment; and intangible assets

 These categories are listed in the order of

how easily they can be converted to cash.

 Some companies group investments,

intangible assets, and other miscellaneous assets into a category called other assets

Current Assets

 Current assets include cash and other assets

that a company can reasonably expect to convert

to cash, sell, or consume within one year or its

normal operating cycle, whichever is longer.

– A company’s normal operating cycle is the average time it needs to go from spending to receiving cash.

– Current assets include: cash; short-term investments;

notes and accounts receivable; inventory that a company expects to convert to cash (by selling it) within the next year or the normal operating cycle; prepaid expenses; and supplies bought for use.

– Securities held for

long-term investment – Long-term notes

receivable – Land held for future

use – Plant or equipment not

used in business

– Special funds established to pay off a debt or buy a building – Large permanent

investments made in another company for the purpose of

controlling that company

 Investments include assets, usually

long-term, that are not used in normal business

operations and that management does not

plan to convert to cash within the next year Examples include:

Property, Plant, and Equipment

 Property, plant, and equipment include

tangible long-term assets used in a business’s day-to-day operations.

– They are also called operating assets, fixed assets,

tangible assets, long-lived assets, or plant assets.

– Through depreciation, the costs of these assets (except land) are spread over the periods they benefit.

– To reduce clutter on the balance sheet, property, plant, and equipment and related accumulated depreciation accounts are often combined—for example:

Property, plant, and equipment (net) $116,240

Intangible Assets

 Intangible assets are long-term assets

with no physical substance Their value

stems from the rights or privileges accruing

to their owners Examples include:

- Current liabilities —

obligations that must

be satisfied within one year or within the

company’s normal operating cycle, whichever is longer.

 Mortgages payable

 Long-term notes

 Bonds payable

 Employee pension obligations

 Long-term lease liabilities

Owner’s Equity

 The terms owner’s equity, proprietorship,

owner’s capital, and net worth are all used

to refer to the owner’s interest, or equity, in

a company.

– The first three terms are preferred to net worth

because many assets are recorded at their original cost rather than at their current value.

 The equity section of the balance sheet

differs depending on whether the business is

a sole proprietorship, partnership, or

corporation.

Sole Proprietorship

 The owner’s equity section of a sole

proprietorship would be similar to the one shown for Bonali Company:

 The equity section of a partnership’s

balance sheet is called partners’

equity

 It is much like that in a sole

proprietorship’s balance sheet and

might appear as follows:

(slide 1 of 2)

 The equity section of a balance sheet for a corporation

is called stockholders’ equity (or shareholders’

equity)

 It has two parts, contributed capital and retained

earnings.

 The Contributed Capital (or Paid-in Capital) account

reflects the amount of assets invested by

stockholders

 It is generally shown on corporate balance sheets by two amounts:

– the face, or par, value of issued stock

– the amounts paid in, or contributed, in excess of the par value per share

(slide 2 of 2)

sometimes called Earned Capital because

it represents the stockholders’ claim to

the assets that are earned from operations and reinvested in corporate operations.

Retained Earnings account just as

withdrawals of assets by the owner of a

business reduce the Capital account.

Overview of Classified Balance Sheet Accounts

income statement can be grouped, as shown below

Using Classified Financial Statements

 Ratios use the components of classified financial statements to reflect how well

a firm has performed in terms of

maintaining liquidity and achieving

profitability.

 Accounts must be classified correctly

before the ratios are computed, or the ratios will be incorrect.

Evaluation of Liquidity

on hand to pay bills when they are due and to take care of unexpected needs

for cash Two measures of liquidity are

working capital and current ratio.

which current assets exceed current

liabilities.

Current Ratio

 The current ratio is the ratio of

current assets to current liabilities.

 To determine whether a current ratio is good or bad, it must be compared with ratios for earlier years and with similar measures for companies in the same

industry.

Evaluation of Profitability

 Profitability is the ability to earn a

satisfactory income

– Profitability competes with liquidity because

liquid assets are not the best profit-producing resources.

– Ratios commonly used to evaluate a company’s ability to earn income include:

Profit Margin

 The profit margin shows the

percentage of each sales dollar that

results in net income.

– It is an indication of how well a company is controlling its costs: the lower its costs, the higher its profit margin.

– To determine whether this is a satisfactory profit, it must be compared with the profit margin of other companies in the same industry.

Asset Turnover

 The asset turnover ratio measures

how efficiently assets are used to

produce sales

– A company with a high asset turnover uses its assets more productively than one with

a low asset turnover.

– Asset turnover is computed by dividing

revenues by average total assets Average total assets are the sum of assets at the beginning and the end of the period,

divided by 2.

Return on Assets

 The return on assets ratio relates net income to average total assets.

– This ratio combines the firm’s

income-generating strength (profit margin) and its revenue-generating effectiveness (asset turnover).

Debt to Equity Ratio

 The debt to equity ratio shows the

proportion of a company’s assets

financed by creditors and the

proportion financed by the owner.

– This ratio is relevant to profitability, as well

as liquidity, because the more debt a company has, the more profit it must earn

to ensure payment of interest to creditors and a return on the owner’s investment.

Return on Equity

 Return on equity is the ratio of net

income to average owner’s equity

– Return on equity will always be greater

than return on assets because total equity will always be less than total assets