Financial Reporting and Analysis – Chapter 4 Financial & Managerial Accounting, 8th Edition by Needles, Powers, Crosson

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Financial Reporting and Analysis – Chapter 4

Financial & Managerial Accounting, 8th Edition by Needles, Powers,

Crosson

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Key Concepts / Terms

• Objectives of financial reporting:1. To furnish information useful in making

investment and credit decisions.

2. To provide information useful in assessing cash flow prospects.

3. To provide information about business resources, claims to those resources, and changes in them.

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• Qualitative characteristics– Understandability: decision makers must be able

to interpret accounting information. To understand accounting information, users must be familiar with the accounting conventions, or rule of thumb, used in preparing financial statements.

– Usefulness: accountants must provide information that is useful in making decisions. The accounting information must be relevant and reliable.

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• Accounting conventions– Comparability: information is presented so that decision

makers can recognize similarities, differences, and trends over different time periods and between companies.

– Consistency: 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.

– Materiality: refers to the relative importance of an item or event. In general, an item or event is material if there is a reasonable expectation that knowing about it would influence the decisions of users of financial statements.

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– Conservatism: when faced with choosing between two equally acceptable procedures, accountants should choose the one that is least likely to overstate assets and income.

– Full Disclosure: requires that financial statements present all the information relevant to users’ understanding of the statements. Statements must offer any explanation needed to keep them from being misleading.

– Cost-benefit: holds that the benefits to be gained from providing accounting information should be greater than the costs of providing it. For example, shoplifting.

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• Usefulness– Relevance: means that the information has a

direct bearing on a decision. In other words, if the information was not available, a different decision would be made.

– Reliability: the user can depend on the information. Information must represent what it is meant to represent.

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• Classified financial statements: general-purpose external financial statements that are divided into subcategories. – Classified balance sheet: Exhibit 1, page 241

• Four categories: current assets, investments, property, plant and equipment, and intangible assets

• Occasionally investments, intangible assets, and other miscellaneous assets will be categorized as other assets.

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• 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. Examples: cash, short-term investments, notes and accounts receivable, and inventory.

• Investments: assets, usually long-term, that are not used in the normal operation of the business and that management does not plan to convert to cash within the next year. Examples include: securities held for long-term investment, long-term notes receivable, land held for future use, plant or equipment not used in the business, and special funds established to pay off a debt or buy a building.

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• Property, plant, and equipment: includes long-term assets used in the continuing operation of the business. These assets represent a place to operate (land and buildings) and equipment to produce, sell, deliver, and service the company’s goods. The cost of these assets is depreciated over the periods they benefit.

• Intangible assets: long-term assets that have no physical substance but have a value based on rights or privileges that belong to their owner. The cost of these assets is amortized over the expected life of the right or privilege. Examples include patents, copyrights, trademarks and brands.

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• Current liabilities: obligations that must be satisfied within one year or within the normal operating cycle, whichever is longer. These liabilities are typically paid from current assets or by incurring new short-term liabilities. Examples include notes payable, accounts payable, current portion of long-term debt, salaries and wages payable, taxes payable, and customer advances (unearned revenues).

• 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 include mortgages payable, long-term notes, bonds payable, employee pension obligations, and long-term lease liabilities.

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• Two forms of income statements: multistep (Exhibit 3, page 248) and single-step (Exhibit 5, page 252).

• Service versus merchandising (buys and sells products) versus manufacturing companies (makes and sells products). Merchandising and manufacturing companies must include an additional step for the cost of goods sold.

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• Components of the multistep income statement (using Exhibit 3)– Net sales (sales): consist of the gross proceeds from sales

(gross sales) less sales returns and allowances and any discounts allowed. • Gross sales: consist of total cash sales and total credit

sales during an accounting period. • Sales returns and allowances: cash refunds, credits on

accounts, and discounts from selling prices made to customers who have received defective products that are otherwise unsatisfactory.

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– Cost of goods sold (cost of sales): an expense that is the amount a merchandiser paid for the merchandise it sold during an accounting period; for a manufacturer, it is the cost of making the products it sold during an accounting period.

– Gross margin (gross profit): the difference between net sales and the cost of goods sold.

– Operating expenses: expenses incurred in running a business other than the cost of goods sold. Often grouped into selling expenses and general and administrative expenses.

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– Income from operations (operating income): the difference between gross margin and operating expenses.

– Other revenues and expenses (nonoperating revenues and expenses): not related to a company’s operating activities. Includes revenues from investments, interest earned on credit or notes extended to customers, interest expense and other expenses that result from borrowing money or from credit extended to the company.

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– Income before income taxes: the amount a company has earned from all activities – operating and nonoperating – before taking into account the amount of income taxes it incurred.

– Income taxes (provision for income taxes): represent the expenses for federal, state, and local taxes on corporate income. ONLY shown for corporations.

– Net income: final figure or “bottom line” of an income statement.

– Earnings per share (net income per share): net income earned on each share of common stock.

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Single-Step Income StatementNotice that income

taxes are shown as a separate step, as in the multistep form. Revenues

Net sales $579,312 Interest income 2,800Total revenues $582,112

Costs and expensesCost of goods sold $362,520 Selling expenses 109,560General and administrative expenses

69,008

Interest expense 5,262Total costs and expenses 546,350

Income before income taxes $35,762 Income taxes 6,762

Net income $29,000

Earnings per share $5.80

Income StatementFor the Year Ended December 31, 20xx

Ling Auto Supply Corporation

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Components of Multistep

Income Statements for

Service and Merchandising

or Manufacturing

Companies

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• Using classified financial statements– Many reasons but two important are to see how

well a company has performed in terms of maintaining liquidity and achieving profitability.

– One way this is accomplished is through the use of ratios.

– Pages 253 through 262 in your textbook.

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• Liquidity1. Working capital = Current assets – current

liabilities.

2. Current ratio = Current Assets ÷ Current liabilities.

A good indicator of a company’s ability to pay its debts on time.

TYPICALLY (depending upon the industry), the higher the ratio the better.

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• Profitability1. Profit margin = Net income ÷ Net sales

Shows the percentage of each sales dollar that results in net income.

2. Asset turnover = Net sales ÷ Average total assets Measures how efficiently assets are used to

produce sales; how many dollars of sales are generated by each dollar of assets.

The higher the turnover, the more assets are used productively.

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3. Return on assets = Net income ÷ Average total assets Indicates the income-generating strength (profit margin) of

the company’s resources and how efficiently the company is using all of its assets (asset turnover).

Combines profit margin and asset turnover.

4. Debt to equity = Total liabilities ÷ Stockholder’s equity

Shows the proportion of a company’s assets that is financed by creditors and the proportion that is financed by stockholders.

Shows how much expansion is possible through borrowing additional long-term funds.

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5. Return on equity = Net income ÷ Average stockholder’s equity

Shows stockholder’s how much they have earned on their investment in the business.

Documents

Financial Reporting and Analysis – Chapter 4 Financial & Managerial Accounting, 8th Edition by Needles, Powers, Crosson