financial reporting and analysis 4. foundations of financial reporting objective 1: describe the...
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Financial Reporting and Analysis 4
Foundations of Financial Reporting
OBJECTIVE 1: Describe the objective of financial reporting and identify the qualitative characteristics, conventions, and ethical considerations of accounting information.
Figure 1: Factors Affecting Financial Reporting
Foundations of Financial Reporting
• Objective of financial reporting– Assess cash flow prospects
• Ability to pay dividends, interest and returns to capital
– Assess stewardship• Provide information about business resources, claims to
those resources, and changes in them
– General-purpose external financial statements consist of the balance sheet, income statement, statement of retained earnings, and statement of cash flows.
Foundations of Financial Reporting
• Qualitative characteristics facilitates a user’s interpretations of accounting information– Information should be relevant, meaning it has
direct bearing on a decision• Predictive value
• Confirmative value
• Both
Foundations of Financial Reporting
• Qualitative characteristics facilitates a user’s interpretations of accounting information (cont.)– The information should be a faithful
representation of the entity.• Complete, neutral, and free from material error
– Information does not have to be absolutely accurate but major uncertainties should be disclosed.
Foundations of Financial Reporting
• Qualitative characteristics facilitates a user’s interpretations of accounting information (cont.)– Four qualitative characteristics complement the
quality of information• Comparability
• Verifiability
• Timeliness
• Understandability
Foundations of Financial Reporting
• Accounting conventions are constraints on accounting and the preparation of financial statements to better enable the user to understand the information being presented.
• Under the Sarbanes-Oxley Act, the CEO and CFO of public companies must certify the financial statements and the system of internal control.
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Accounting Conventions for Preparing Financial Statements
OBJECTIVE 2: Define and describe the conventions of consistency, full disclosure, materiality, conservatism, and cost-benefit.
Accounting Conventions for Preparing Financial Statements
• Consistency– Once a company has adopted an accounting
procedure, it must use it from one period to the next unless otherwise noted.
Accounting Conventions for Preparing Financial Statements
• Full disclosure (transparency)– Financial statements must present all
information relevant to users’ understanding of the statements
– Explanatory notes disclosing changes in account procedures, or significant events occurring after balance sheet dates
Accounting Conventions for Preparing Financial Statements
• Materiality– Relative importance of an item or event– Materiality determined by relating its dollar
value to an element of the financial statements
Accounting Conventions for Preparing Financial Statements
• Conservatism– When a choice between two equally acceptable
procedures, chose the one least like to overstate assets or income
– Useful, but can be abused, so accountants should only depend on it when uncertain about which procedure or estimate to use.
• Cost-benefit– The benefit gained from providing information should
be greater than the cost of providing it.– Costs and benefits are both immediate and deferred.
Accounting Conventions for Preparing Financial Statements
• Cost-benefit– The benefit gained from providing information
should be greater than the cost of providing it.– Costs and benefits are both immediate and
deferred.
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Classified Balance Sheet
OBJECTIVE 3: Identify and describe the basic components of a classified balance sheet.
Classified Balance Sheet
• Classified financial statements are general-purpose external financial statements that are divided into subcategories to provide more useful information to the reader.
• A classified balance sheet divides assets, liabilities, and stockholders’ equity into subcategories to facilitate decision-making.
Figure 2 Classified Balance Sheet
Classified Balance Sheet
• There are usually four categories of assets on the classified balance sheet. These categories are listed in declining order of liquidity. (Some companies use another category called other assets to group all assets other than current assets and property, plant, and equipment.) – Current assets
• The normal operating cycle, a concept used in the classification of assets, is the time a company needs to go from spending cash to receiving cash.
– Investments– Property, plant, and equipment– Intangible assets
Classified Balance Sheet
• Liabilities on the classified balance sheet are usually divided into two categories.– Current liabilities
– Long-term liabilities
• Stockholder’s equity– Contributed capital
• Par value of stock
• Additional paid-in capital, (amount paid above par value)
– Retained earnings
Classified Balance Sheet
• Owner’s Equity and Partners’ Equity– In a sole proprietorship the owner’s equity
section shows the capital in the owner’s name at an amount equal to the net assets of the company.
Exhibit 1 Classified Balance Sheet for Cruz Corporation
Exhibit 1 Classified Balance Sheet for Cruz Corporation (cont.)
Exhibit 2 Classified Balance Sheet for Dell Corporation
Exhibit 2 (Continued)
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Forms of the Income Statement
OBJECTIVE 4: Describe the features of multistep and single-step classified income statements.
Figure 3: The Components of Multistep Income Statements for Service and Merchandising or Manufacturing Companies
Exhibit 3: Multistep Income Statement for Cruz Company
Exhibit 4: Multistep Income Statement for Dell Computer Corporation
Exhibit 5: Single-Step Income Statement for Cruz Company
Forms of the Income Statement
• The multistep income statement arrives at net income through a series of steps, or subtotals, including gross margin and income from operations.– Net sales– Cost of goods sold– Gross margin– Operating expenses– Income from operations– Other revenues and expenses– Income taxes– Net income
Forms of the Income Statement
• The single-step income statement arrives at net income in a single step. The single-step form is a simple deduction of all costs and expenses from all revenues.
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Using Classified Financial Statements
OBJECTIVE 5: Use classified financial statements to evaluate liquidity and profitability.
Figure 4: Average Current Ratio for Selected Industries
Figure 5: Average Profit Margin for Selected Industries
Figure 6: Average Asset Turnover for Selected Industries
Figure 7: Average Return on Assets for Selected Industries
Figure 8: Average Debt to Equity Ratio for Selected Industries
Figure 9: Average Return on Equity for Selected Industries
Using Classified Financial Statements
• Liquidity measures a company’s ability to pay its bills when they fall due.– Working capital is current assets minus current
liabilities.– The current ratio is current assets divided by
current liabilities.
Using Classified Financial Statements
• Profitability may be measured several ways.– Profit margin—net income divided by net sales– Asset turnover—net sales divided by average total assets– Return on assets—net income divided by average total
assets– Debt to equity ratio—total liabilities divided by
stockholders’ equity– Return on equity—net income divided by average
stockholders’ equity
©2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part.