Accounting-7th ed - notes 02 PDF

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ACCT 2101-Principles of Accounting I Accounting - Kimmel, Weygandt, Kieso Joe Patterson

CHAPTER 2 A FURTHER LOOK AT FINANCIAL STATEMENTS Learning Objective 1 Identify the sections of a classified balance sheet. Classified balance sheet -Assets -current assets – cash, assets the business expects to convert to cash within a year, and assets the business expects to use within a year; current assets are listed in the order of liquidity (the order in which they are expected to be converted into cash). -long-term investments -investments in stocks and bonds of other companies held for more than 1 year, -long-term assets such as land and buildings that a company is not currently using in its operating activities, and -long-term notes receivable -property, plant, and equipment - assets with long useful lives used in operating the business -intangible assets – noncurrent assets that do not have physical substance. Intangible assets often represent rights or privileges (patents, copyrights). -Liabilities -current liabilities - liabilities that will be paid within one year of the balance sheet date -long-term liabilities - liabilities that will be paid after one year from the balance sheet date -Stockholders’ equity

Learning Objective 2 Use ratios to evaluate a company’s profitability, liquidity, and solvency. Ratio analysis -Expresses the relationship among selected financial statement data as a fraction -What you need to know -Where do you get the information for the ratio? -What does the ratio mean? How is the ratio used to evaluate the business? -Is a higher or lower result better? -Why is a higher or lower result better?

Three types of comparisons -Comparisons used to know if a particular company’s ratios are high enough or low enough -intracompany comparisons (comparisons with past results for the same company) -Caution-A company could be improving but still have problems. -intercompany comparisons (comparisons with a competitor in the same industry) -Caution-The competitor could have problems. -industry average comparisons (comparisons with published data for particular industries) -This is the best standard or benchmark.

Ratio analysis-averages -In some ratios, both the number on the top and the number on the bottom are income statement or balance sheet numbers. In other ratios, one of the numbers is an income statement number and the other number is a balance sheet number. In this second situation, the balance sheet number will be an average of the beginning and ending balances. This is done because the income statement number measures activity across a period, and the balance sheet number shows an amount at a point in time (Balance sheet numbers at end of period 1 are balance sheet numbers at beginning of period 2). -Note: A statement of cash flows number is used in some ratios. It is treated like an income statement number because the statement of cash flows measures activity across a period.

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ACCT 2101-Principles of Accounting I Accounting - Kimmel, Weygandt, Kieso Joe Patterson

Ratio analysis-what ratios measure -Profitability - measures the income or operating success of a company for a given period of time -Liquidity - measures the short term (1 year) ability of the company to pay current liabilities and to meet other needs for cash -Solvency - measures the long-term ability of the company to pay all liabilities and to meet other needs for cash

Earnings per share (measures profitability) net income minus preferred stock dividends weighted average number of common shares outstanding -Sources -net income from the income statement -preferred stock dividends from the statement of retained earnings -average number of common shares outstanding from the balance sheet -Shows the net income earned on each share of common stock -High or low? HIGH - The stockholder wants to earn more net income for each of his shares.

Working capital (not really a ratio; measures liquidity) -Current assets minus current liabilities -Sources -current assets from the balance sheet -current liabilities from the balance sheet -Shows ability to pay current liabilities; shows the excess of current assets over current liabilities -High or low? HIGH - Creditors want more dollars in current assets than current liabilities.

Current ratio (measures liquidity) current assets current liabilities -Sources -current assets from the balance sheet -current liabilities from the balance sheet -Shows ability to pay current liabilities; shows dollars of current assets for one dollar of current liabilities -High or low? HIGH - Creditors want more dollars of current assets for each dollar of current liabilities.

Debt to total assets (measures solvency) total liabilities total assets -Sources -total liabilities from the balance sheet -total assets from the balance sheet -Shows the percentage of assets financed by creditors; shows the ability of the company to pay all liabilities -High or low? LOW - Creditors are concerned if the company has excessive debt.

Free cash flow (not really a ratio; measures solvency) -Net cash provided by operating activities minus capital expenditures and cash dividends -Sources -net cash provided by operating activities from the statement of cash flows -capital (property, plant, and equipment) expenditures from the investing activities section of the statement of cash flows -cash dividends from the financing activities section of the statement of cash flows -Shows the amount of operating cash the company has after buying property, plant, and equipment and paying dividends

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ACCT 2101-Principles of Accounting I Accounting - Kimmel, Weygandt, Kieso Joe Patterson

-High or low? HIGH -The company wants more extra operating cash to pay debts or add to its solvency.

Learning Objective 3 Discuss financial reporting concepts. Financial reporting-the standard setting environment -Financial reporting-all financial information presented by a company both in its financial statements and in additional disclosures; primary objective is to provide information useful for decision making -is normally done at the end of a month, a quarter, or a fiscal year (accounting year) -fiscal year can be any 12 month period (not always Jan 1-Dec 31) -Generally Accepted Accounting Principles (GAAP) - rules for financial reporting determined by FASB -Financial Accounting Standards Board (FASB) -is the primary accounting standard setting body for private companies in the US -is not a government agency -is supported by the accounting profession and business community -has power because the SEC almost always requires publicly traded corporations to follow GAAP determined by the FASB -Securities and Exchange Commission (SEC) -is an agency of the US government -oversees US financial markets and accounting standard setting bodies -almost always requires publicly traded corporations to follow GAAP determined by the FASB -International Accounting Standards Board (IASB) -issues International Financial Reporting Standards (IFRS) -have been adopted by many countries outside the US -are now OK for foreign companies trading on US stock exchanges -is working with the FASB to minimize the differences in IASB and FASB standards -Public Company Accounting Oversight Board (PCAOB) -was created by the Sarbanes-Oxley Act (sometimes called SOX; passed in 2002) -determines auditing standards and reviews the performance of auditing firms

Financial reporting-qualities of useful information -Two fundamental qualities -relevance - The information would make a difference in a business decision. -predictive value – The information helps provide accurate future expectations. -confirmatory value – The information confirms or corrects prior expectations. -materiality – An item is material when its size makes it likely to influence the decision of an investor or creditor. -faithful representation – The information accurately depicts what really happened. -complete – Nothing important has been omitted from the information. -neutral – The information is not biased toward one position or another. -free from error – The information does not have errors. -Enhancing qualities -comparability – results when different companies use the same accounting principles -GAAP sometimes allows companies to make choices about accounting methods. When comparing two companies, you should consider those choices. -consistency – means that a company uses the same accounting principles from year to year - GAAP sometimes allows companies to make choices about accounting methods. Normally, after a company makes a choice, it must stay with that choice in future periods (There are exceptions.). -verifiable –means that independent observers, using the same methods, obtain similar results -timely – means the information is available to decision makers when it can influence decisions

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ACCT 2101-Principles of Accounting I Accounting - Kimmel, Weygandt, Kieso Joe Patterson

-understandability – means that the information is presented in a clear and concise fashion

Financial reporting-assumptions in financial reporting -Monetary unit assumption – Only transaction data that can be expressed in terms of money is included in the accounting records. This means that certain important information (for example, customer satisfaction) is not reported in the financial statements. -Economic entity assumption – Every economic entity can be separately identified and accounted for. -Time period assumption (also called the periodicity assumption) – The economic life of a business can be divided into artificial time periods and useful reports covering those periods can be prepared. -Going concern assumption – The business will remain in operation for the foreseeable future.

Financial reporting-principles in financial reporting -Measurement principles -Cost principle (also called the historical cost principle) – Assets are recorded at cost. Most assets are not adjusted to market valuations (There are exceptions.). -Fair value principle – Assets and liabilities are reported at fair value (the price that would be received to sell an asset or settle a liability). Only in situations where assets are actively traded (for example, investment securities) is the fair value principle applied. -Full Disclosure principle – All circumstances and events that make a difference to financial statement users must be disclosed (presented in the financial statements or notes to the financial statements).

Financial reporting-constraints in financial reporting -Cost (constraint not principle) – Weighing the cost that companies will incur to provide accounting information against the benefit that financial statement users will gain from having the information -Materiality - Determining whether an item is large enough to likely influence the decision of an investor or creditor -Conservatism - Choosing an accounting method when in doubt that will least likely overstate assets and net income

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