CHAPTER 4

Financial Reporting and Analysis

REVIEWING THE CHAPTERObjective 1: Describe the objectives and qualitative characteristics of financial reporting and the ethical responsibilities that financial reporting involves.

1. Financial reporting should fulfill three objectives. It should (a) furnish information that is useful in making investment and credit decisions; (b) provide information that is useful in assessing cash flow prospects; and (c) provide information about business resources, claims to those resources, and changes in them. General-purpose external financial statements are the main way of presenting financial information to interested parties. They consist of the balance sheet, income statement, statement of owner’s equity, and statement of cash flows.

2. Accounting attempts to provide decision makers with information that displays certain qualitative characteristics, or standards:

a. Understandability is the qualitative characteristic of information that enables users to perceive its meaning. To understand accounting information, users must be familiar with the accounting conventions, or rules of thumb (discussed in paragraph 4 below), used in preparing financial statements.

b. Another very important standard is usefulness. To be useful, information must be relevant and reliable. Relevance means that the information is capable of influencing a decision. Relevant information provides feedback, helps in making predictions, and is timely. Reliability means that the information accurately reflects what it is meant to reflect, that it is credible, verifiable, and neutral.

3. Users of financial statements depend on a company’s management and accountants to act ethically and with good judgment in preparing the statements. One product of the Sarbanes-Oxley Act is that the chief executive officers and chief financial officers of all publicly traded companies are required to certify that, to their knowledge, the quarterly and annual statements filed with the SEC are accurate and complete. Persons found guilty of fraudulent financial reporting are subject to criminal penalties and fines.

Objective 2: Define and describe the conventions of comparability and consistency, materiality, conservatism, full disclosure, and cost-benefit.

4. To help users interpret financial information, accountants depend on five conventions: comparability and consistency, materiality, conservatism, full disclosure, and cost-benefit.

a. Comparability means that the information allows the decision maker to compare the same company over two or more accounting periods or different companies over the same accounting period. Consistency means that a particular accounting procedure, once adopted, should not be changed unless management decides it is no longer appropriate or unless reporting requirements change. The nature of the change, its justification, and its dollar effect on income should be disclosed in the notes to the financial statements.

b. The materiality convention states that strict accounting practice need not be applied to items of insignificant dollar value. Whether a dollar amount is material is a matter of professional judgment, which should be exercised in a fair and accurate manner.

c. The conservatism convention states that an accountant who has a choice of acceptable accounting procedures should choose the one that is least likely to overstate assets and income. Applying the lower-of-cost-or-market rule to inventory valuation is an example of conservatism.

d. The full disclosure convention states that financial statements and their notes should contain all information relevant to the user’s understanding of the statements. Disclosures of such matters as accounting changes, commitments and contingencies, and the accounting methods used are essential for a full understanding of the financial statements.

e. The cost-benefit convention states that the benefits to be gained from providing accounting information should be greater than the cost of providing it. For example, a department store is following this convention when it decides not to hire significantly more clerks to achieve a modest reduction in shoplifting.

Objective 3: Identify and describe the basic components of a classified balance sheet.

5. Classified financial statements are general-purpose external financial statements that divide assets, liabilities, owner’s equity, revenues, and expenses into subcategories, thus making the statements more useful to readers.

6. On a classified balance sheet, assets are usually divided into four categories: (a) current assets; (b) investments; (c) property, plant, and equipment; and (d) intangible assets. These categories are listed in order of liquidity (the ease with which an asset can be turned into cash). For simplicity, some companies group investments, intangible assets, and miscellaneous assets (i.e., all assets other than current assets and property, plant, and equipment) into a category called other assets.

a. Current assets are cash and other assets (including short-term investments, accounts and notes receivable, prepaid expenses, supplies, and inventory) that are expected to be turned into cash or used up within a company’s normal operating cycle or within one year, whichever is longer. (From here on, we will call this time period the current period.) A company’s normal operating cycle is the average time between the purchase of inventory and the collection of cash from the sale of that inventory.

b. Examples of investments are stocks and bonds held for long-term investment, land held for future use, plant or equipment that is not used in the business, special funds, and large permanent investments made to control another company.

c. Property, plant, and equipment (also called operating assets, fixed assets, tangible assets, long-lived assets, or plant assets) include things like land, buildings, delivery equipment, machinery, office equipment, and natural resources. Most of the assets in this category are subject to depreciation.

d. Intangible assets have no physical substance. Their value stems from the rights or privileges they extend to their owners. Examples are patents, copyrights, goodwill, franchises, and trademarks.

7. Liabilities on a classified balance sheet are divided into current and long-term liabilities.

a. Current liabilities are obligations for which payment (or performance) is due in the current period. They are paid from current assets or by incurring new short-term

liabilities. Examples of current liabilities include notes payable, accounts payable, salaries and wages payable, the current portion of long-term debt, and customer advances (unearned revenues).

b. Long-term liabilities are debts that are due after the current period or that will be paid from noncurrent assets. Examples are mortgages payable, long-term notes payable, bonds payable, employee pension obligations, and long-term lease liabilities.

8. The owner’s equity section of a classified balance sheet is usually called owner’s equity, partners’ equity, or stockholders’ equity. The exact name depends on whether the business is a sole proprietorship, a partnership, or a corporation. Other descriptive terms for owner’s equity are proprietorship, capital, and the somewhat misleading term net worth.

a. In a sole proprietorship or partnership, the owner’s or partners’ equity section shows the name of the owner or owners. Each is followed by the word capital and the dollar amount of investment as of the balance sheet date.

b. The stockholders’ equity section of a corporation consists of contributed capital (also called paid-in capital) and retained earnings (sometimes called earned capital). Contributed capital is the amount invested by the stockholders. It is generally shown on the balance sheet at the par value of the issued stock and at the amount contributed in excess of par value (called additional paid-in capital). Retained earnings reflect the earnings record of the corporation since its inception. Dividends (assets distributed to stockholders) reduce the Retained Earnings account balance, as do net losses.

Objective 4: Describe the features of multistep and single-step classified income statements.

9. An income statement may be presented in either multistep or single-step form. The multistep income statement is the more detailed of the two, containing several subtractions and subtotals. A merchandiser’s or manufacturer’s multistep income statement has separate sections for cost of goods sold, operating expenses, and other (nonoperating) revenues and expenses.

10. On the multistep income statements of merchandising companies (which buy and sell finished products) and manufacturing companies (which make and sell products), net income is computed as follows:

Net sales− Cost of goods sold= Gross margin− Operating expenses= Income from operations± Other revenues and expenses= Net income

The multistep income statement of a service company is prepared in the same manner, except that it does not contain cost of goods sold or gross margin.

a. Net sales (also called sales) consist of gross proceeds from the sale of merchandise (gross sales) less sales returns and allowances and sales discounts.

b. Cost of goods sold (also called cost of sales) is the amount a merchandising company paid for the goods that it sold during an accounting period. If, for example, a merchandiser sells for $100 a radio that cost the firm $70, then revenue from the sale is $100, cost of goods sold is $70, and gross margin (also called gross profit) is $30. The gross margin helps pay for operating expenses (all expenses other than cost of goods sold and income taxes). What is left after subtracting operating expenses represents income from operations (also called operating income).

c. Operating expenses consist of selling expenses and general and administrative expenses. Selling expenses are directly related to the sales effort. They include advertising expenses, salespeople’s salaries, sales office expenses, and freight-out expense. General and administrative expenses are not directly related to the

manufacturing or sales effort. Examples are general office expenses and executive salaries.

d. Other revenues and expenses are nonoperating items, such as interest income and interest expense. A corporate income statement should disclose income taxes (also called provision for income taxes) separately from the other expenses.

e. Net income, often described as the bottom line, is what remains of the gross margin after operating expenses have been deducted, and other revenues and expenses have been added or deducted.

11. In the single-step income statement, the revenues section lists all revenues, including other revenues, and the costs and expenses section lists all expenses, including cost of goods sold and other expenses. A condensed version of the single-step form is as follows:

Revenues X− Costs and expenses X= Net income X

Objective 5: Use classified financial statements to evaluate liquidity and profitability.

12. Classified financial statements help the reader evaluate liquidity and profitability.

13. Liquidity refers to a company’s ability to pay its bills when they are due and to meet unexpected needs for cash. Two measures of liquidity are working capital and the current ratio.

a. Working capital equals current assets minus current liabilities. It is the amount of current assets that would remain if all current debts were paid.

b. The current ratio equals current assets divided by current liabilities. A current ratio of 1:1, for example, shows that current assets are just enough to pay current liabilities. A 2:1 current ratio is considered more satisfactory.

14. Profitability refers to a company’s ability to earn a satisfactory income. To draw conclusions about profitability, one must compare profitability measures with past performance and industry averages. Five common measures of profitability are profit margin, asset turnover, return on assets, debt to equity ratio, and return on equity.

a. The profit margin equals net income divided by net sales. A 12.5 percent profit margin, for example, means that 12½ cents have been earned on each dollar of sales.

b. Asset turnover equals net sales divided by average total assets. This measure shows how efficiently a company is using its assets to produce sales.

c. Return on assets equals net income divided by average total assets. This measure shows how efficiently a company is using its assets to produce income.

d. The debt to equity ratio measures the proportion of a business financed by creditors relative to the proportion financed by owners. It equals total liabilities divided by owner’s equity. A debt to equity ratio of 1.0, for instance, indicates equal financing by creditors and owners.

e. Return on equity shows what percentage was earned on the owner’s investment. It equals net income divided by average owner’s equity.