BUS 591 Week 1 Discussion 1&2

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Financial Accounting: Tools for Business Decision Making

Eighth Edition

Kimmel ● Weygandt ● Kieso

Chapter 2

A Further Look at Financial Statements

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Financial Accounting: Tools for Business Decision Making

Chapter Outline:

Learning Objectives

Identify the sections of a classified balance sheet.

Use ratios to evaluate a company’s profitability, liquidity, and solvency.

Discuss financial reporting concepts.

L O 1: Identify the Sections of a Classified Balance Sheet

Presents a snapshot at a point in time.

To improve understanding, companies group similar assets and similar liabilities together.

Standard Classifications

Assets	Liabilities and Stockholders’ Equity
Current assets	Current liabilities
Long-term investments	Long-term liabilities
Property, plant, and equipment	Stockholders’ equity
Intangible assets	Blank

Identify the Sections of a Classified Balance Sheet (1 of 2)

Identify the Sections of a Classified Balance Sheet (2 of 2)

The Classified Balance Sheet (1 of 16)

Current Assets

Assets that a company expects to convert to cash or use up within one year or the operating cycle, whichever is longer.

Operating cycle is the average time it takes from the purchase of inventory, to the sale of goods, and then to the collection of cash from customers.

Common types of current assets are (1) cash, (2) investments, (3) receivables, (4) inventories, and (5) prepaid expenses.

The Classified Balance Sheet (2 of 16)

Current Assets

Companies list current asset accounts in the order they expect to convert them into cash.

The Classified Balance Sheet (3 of 16)

Review Question

Cash, and other resources that are reasonably expected to be realized in cash or sold or consumed in the business within one year or the operating cycle, are called:

a. Current assets.

b. Intangible assets.

c. Long-term investments.

d. Property, plant, and equipment.

The Classified Balance Sheet (4 of 16)

Review Question

Cash, and other resources that are reasonably expected to be realized in cash or sold or consumed in the business within one year or the operating cycle, are called:

a. Current assets.

b. Intangible assets.

c. Long-term investments.

d. Property, plant, and equipment.

The Classified Balance Sheet (5 of 16)

Long-Term Investments

Investments in stocks and bonds of other corporations that are held for more than one year.

Long-term assets such as land or buildings that a company is not currently using in its operating activities.

Long-term notes receivable.

The Classified Balance Sheet (6 of 16)

Property, Plant, and Equipment

Long useful lives.

Currently used in operations.

Includes land, buildings, equipment, delivery vehicles, and furniture.

Depreciation - allocating the cost of assets to a number of years.

Accumulated depreciation - total amount of depreciation expensed thus far in the asset’s life.

Alternative Terminology

Property, plant, and equipment is sometimes called fixed assets or plant assets.

Property, Plant, and Equipment

The Classified Balance Sheet (7 of 16)

Intangible Assets

Assets that do not have physical substance.

Includes goodwill, patents, copyrights, and trademarks or trade names.

▼Helpful Hint

Sometimes intangible assets are reported under a broader heading called “Other assets.”

The Classified Balance Sheet (8 of 16)

Intangible Assets

The Classified Balance Sheet (9 of 16)

Review Question

Patents and copyrights are

a. Current assets.

b. Intangible assets.

c. Long-term investments.

d. Property, plant, and equipment.

The Classified Balance Sheet (10 of 16)

Review Question

Patents and copyrights are

a. Current assets.

b. Intangible assets.

c. Long-term investments.

d. Property, plant, and equipment.

Do It! 1a: Assets Section of Classified Balance Sheet (1 of 3)

Baxter Hoffman recently received the following information related to Hoffman Corporation’s December 31, 2017, balance sheet.

Prepaid insurance	$ 2,300
Cash	800
Equipment	10,700
Accounts receivable	1,100

Inventory	$3,400
Accumulated depreciation-equipment	2,700

Prepare the assets section of Hoffman Corporation’s classified balance sheet.

Do It! 1a: Assets Section of Classified Balance Sheet (2 of 3)

Prepare the assets section of the classified balance sheet.

Prepaid insurance	$ 2,300
Cash	800
Equipment	10,700
Accounts receivable	1,100

Inventory	$3,400
Accumulated depreciation-equipment	2,700

Do It! 1a: Assets Section of Classified Balance Sheet (3 of 3)

The Classified Balance Sheet (11 of 16)

Current Liabilities

Obligations the company is to pay within the next year or operating cycle, whichever is longer.

Common examples are accounts payable, salaries and wages payable, notes payable, interest payable, and income taxes payable.

Also included as current liabilities are current maturities of long-term obligations—payments to be made within the next year on long-term obligations.

The Classified Balance Sheet (12 of 16)

Current Liabilities

The Classified Balance Sheet (13 of 16)

Long-Term Liabilities

Obligations a company expects to pay after one year.

Include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities.

The Classified Balance Sheet (14 of 16)

Review Question

Which of the following is not a long-term liability?

a. Bonds payable.

b. Current maturities of long-term debt.

c. Long-term notes payable.

d. Mortgages payable.

The Classified Balance Sheet (15 of 16)

Review Question

Which of the following is not a long-term liability?

a. Bonds payable.

b. Current maturities of long-term debt.

c. Long-term notes payable.

d. Mortgages payable.

The Classified Balance Sheet (16 of 16)

Stockholders’ Equity

Common stock - investments of assets into the business by the stockholders.

Retained earnings - income retained for use in the business

Stockholders’ Equity section for Franklin Corporation

Do It! 1b: Balance Sheet Classifications (1 of 3)

Match each of the items to its proper balance sheet classification, shown below. If the item would not appear on a balance sheet, use “NA.”

Current assets (CA)	Current liabilities (CL)
Long-term investments (LTI)	Long-term liabilities (LTL)
Property, plant, and equipment (PPE)	Stockholders’ equity (SE)
Intangible assets (IA)	Blank

Do It! 1b: Balance Sheet Classifications (2 of 3)

Blank	Salaries and wages payable	Blank	Investment in real estate
Blank	Service revenue	Blank	Equipment
Blank	Interest payable	Blank	Accumulated depreciation
Blank	Goodwill	Blank	Debt investments (short-term)
Blank	Depreciation expense	Blank	Retained earnings
Blank	Mortgage payable (due in 3 years)	Blank	Unearned service revenue

Do It! 1b: Balance Sheet Classifications (3 of 3)

CL	Salaries and wages payable	LTI	Investment in real estate
NA	Service revenue	PPE	Equipment
CL	Interest payable	PPE	Accumulated depreciation
IA	Goodwill	CA	Debt investments (short-term)
NA	Depreciation expense	SE	Retained earnings
LTL	Mortgage payable (due in 3 years)	CL	Unearned service revenue

L O 2: Use Ratios to Evaluate a Company's Profitability, Liquidity, and Solvency

Ratio Analysis

Ratio analysis expresses the relationship among selected items of financial statement data.

A ratio expresses the mathematical relationship between one quantity and another.

A single ratio by itself is not very meaningful.

Ratio Analysis

Using the Income Statement (1 of 3)

Earnings per Share

Profitability Ratio

Illustration: Earnings per share (EPS) measures the net income earned on each share of common stock.

in millions	2014	2013
Net income	$ 532	$(441)
Preferred (loss)	-0-	-0-
Share out standing at beginning of year	338	341
Share out standing at end of year	347	338

Using the Income Statement (2 of 3)

Review Question

For 2017 Stoneland Corporation reported net income $26,000; net sales $400,000; and average shares outstanding 6,000. There were preferred stock dividends of $2,000. What was the 2017 earnings per share?

a. $4.00

b. $0.06

c. $16.67

d. $66.67

Using the Income Statement (3 of 3)

Review Question

a. $4.00

b. $0.06

c. $16.67

d. $66.67

Using a Classified Balance Sheet (1 of 5)

Using a Classified Balance Sheet (2 of 5)

Liquidity—the ability to pay obligations expected to become due within the next year or operating cycle.

Working capital is the difference between the amounts of current assets and current liabilities.

Best Buy had working capital in 2014 of $3,049 million ($10,485 million − $7,436 million).

Using a Classified Balance Sheet (3 of 5)

Liquidity ratios measure the short-term ability to pay maturing obligations and to meet unexpected needs for cash.

For every dollar of current liabilities, Best Buy has $1.41 of current assets.

Accounting Across the Organization (1 of 2)

Can a Company Be Too Liquid?

There actually is a point where a company can be too liquid—that is, it can have too much working capital. While it is important to be liquid enough to be able to pay short-term bills as they come due, a company does not want to tie up its cash in extra inventory or receivables that are not earning the company money. By one estimate from the REL Consultancy Group, the thousand largest U.S. companies had cumulative excess working capital of $1.017 trillion in a recent year. This was an 18% increase, which REL said represented a“ deterioration in the management of operations.” Given that managers throughout a company are interested in improving profitability, it is clear that they should have an eye toward managing working capital. They need to aim for a “Goldilocks solution”—not too much, not too little, but just right.

Source: Maxwell Murphy, “The Big Number,” Wall Street Journal (November 9, 2011).

Using a Classified Balance Sheet (4 of 5)

Solvency—the ability to pay interest as it comes due and to repay the balance of a debt due at its maturity.

Solvency ratios measure the ability of the company to survive over a long period of time.

▼Helpful Hint Some users evaluate solvency using a ratio of liabilities divided by stockholders’ equity. The higher this “debt to equity” ratio, the lower is a company’s solvency.

Using a Classified Balance Sheet (5 of 5)

Debt to assets ratio measures the percentage of total financing provided by creditors rather than stockholders.

The 2014 ratio means that every dollar of assets was financed by 72 cents of debt.

Investor Insight

When Debt Is Good

Debt financing differs greatly across industries and companies. Here are some debt to assets ratios for selected companies in a recent year:

Blank	Debt to Assets Ratio
Google	23%
Nike	41%
Microsoft	48%
ExxonMobil	48%
General Motors	74%

Using the Statement of Cash Flows (1 of 2)

In the Statement of Cash Flows, cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment and must maintain dividends at current levels to satisfy investors.

Free cash flow describes the net cash provided by operating activities after adjusting for capital expenditures and dividends paid.

Using the Statement of Cash Flows (2 of 2)

Illustration: M P C produced and sold 10,000 personal computers this year. It reported $100,000 cash provided by operating activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Calculate free cash flow.

Cash provided by operating activities	$100,000
Less: Expenditures on property, plant, and equipment	−15,000
Dividends paid	5,000
Free cash flow	$$$ 80000 double underline

Do It! 2: Ratio Analysis (1 of 4)

Blank	2017	2018
Current assets	$ 88,000	$ 60,800
Total assets	400,000	341,000
Current liabilities	40,000	38,000
Total liabilities	120,000	150,000
Net income	100,000	50,000
Net cash provided by operating activities	110,000	70,000
Preferred dividends	10,000	10,000
Common dividends	5,000	2,500
Expenditures on PP&E	45,000	20,000
Shares outstanding at beginning of year	60,000	40,000
Shares outstanding at end of year	120,000	60,000

Do It! 2: Ratio Analysis (2 of 4)

(a) Compute earnings per share for 2017 and 2016 for Ozone. Ozone’s primary competitor, Frost Corporation, had earnings per share of $2 in 2017.

Solution

Earnings per share

Do It! 2: Ratio Analysis (3 of 4)

(b) Compute the current ratio and debt to assets ratio for 2017.

Solution

Current Ratio

Debt to Assets ratio

Do It! 2: Ratio Analysis (4 of 4)

(b) Compute free cash flow for each year.

Solution

blank	2017	2016
Net cash provided by operating activities	$110,000	$70,000
Expenditures on PP&E	− 45,000	− 20,000
Preferred dividend	− 10,000	− 10,000
Common dividends	− 5,000	− 2,500
Blank	$50,000 double underline	$37,500 double underline

L O 3: Discuss Financial Reporting Concepts

The Standard-Setting Environment

Generally Accepted Accounting Principles (G A A P) - A set of rules and practices, having substantial authoritative support, that the accounting profession recognizes as a general guide for financial reporting purposes.

Standard-setting bodies determine these guidelines:

Securities and Exchange Commission (S E C)

Financial Accounting Standards Board (F A S B)

International Accounting Standards Board (I A S B)

Public Company Accounting Oversight Board (P C A O B)

International Note Over 115 countries use international standards (called I F R S).

The Standard-Setting Environment (1 of 4)

Review Question

Generally accepted accounting principles are:

a. a set of standards and rules that are recognized as a general guide for financial reporting.

b. usually established by the Internal Revenue Service.

c. the guidelines used to resolve ethical dilemmas.

d. fundamental truths that can be derived from the laws of nature.

The Standard-Setting Environment (2 of 4)

Review Question

Generally accepted accounting principles are:

a. a set of standards and rules that are recognized as a general guide for financial reporting.

b. usually established by the Internal Revenue Service.

c. the guidelines used to resolve ethical dilemmas.

d. fundamental truths that can be derived from the laws of nature.

International Insight

The Korean Discount

If you think that accounting standards don’t matter, consider recent events in South Korea. For many years, international investors complained that the financial reports of South Korean companies were inadequate and inaccurate. Accounting practices there often resulted in huge differences between stated revenues and actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of comparable companies in different countries. This difference in share price was often referred to as the “Korean discount.” In response, Korean regulators decided that companies would have to comply with international accounting standards. This change was motivated by a desire to “make the country’s businesses more transparent” in order to build investor confidence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international standards or to create standards that are based on the international standards.

Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).

Qualities of Useful Information (1 of 3)

According to the F A S B, useful information should possess two fundamental qualities, relevance and faithful representation.

Relevance Accounting information has relevance if it would make a difference in a business decision. Information is considered relevant if it provides information that has predictive value, that is, helps provide accurate expectations about the future, and has confirmatory value, that is, confirms or corrects prior expectations. Materiality is a company-specific aspect of relevance. An item is material when its size makes it likely to influence the decision of an investor or creditor.

Qualities of Useful Information (2 of 3)

According to the F A S B, useful information should possess two fundamental qualities, relevance and faithful representation.

Faithful Representation Faithful representation means that information accurately depicts what really happened. To provide a faithful representation, information must be complete (nothing important has been omitted), neutral (is not biased toward one position or another), and free from error.

Qualities of Useful Information (3 of 3)

Enhancing Qualities

Comparability results when different companies use the same accounting principles.

Information is verifiable if independent observers, using the same methods, obtain similar results.

Information has the quality of understandability if it is presented in a clear and concise fashion.

Consistency means that a company uses the same accounting principles and methods from year to year.

For accounting information to have relevance, it must be timely.

Accounting Across the Organization (2 of 2)

What Do These Companies Have in Common?

Another issue related to comparability is the accounting time period. An accounting period that is one-year long is called a fiscal year. But a fiscal year need not match the calendar year. For example, a company could end its fiscal year on April 30 rather than on December 31. Why do companies choose the particular year-ends that they do? For example, why doesn’t every company use December 31 as its accounting year-end? Many companies choose to end their accounting year when inventory or operations are at a low point. This is advantageous because compiling accounting information requires much time and effort by managers, so they would rather do it when they aren’t as busy operating the business. Also, inventory is easier and less costly to count when its volume is low. Some companies whose year-ends differ from December 31 are Delta Air Lines, June 30; The Walt Disney Company, September 30; and Dunkin’ Donuts, Inc., October 31. In the notes to its financial statements, Best Buy states that its accounting year-end is the Saturday nearest the end of January.

Assumptions in Financial Reporting (1 of 2)

Monetary Unit Assumption

Requires that only those things that can be expressed in money are included in the accounting records.

Economic Entity Assumption

States that every economic entity can be separately identified and accounted for.

Assumptions in Financial Reporting (2 of 2)

Periodicity Assumption

States that the life of a business can be divided into artificial time periods.

Going Concern Assumption

the business will remain in operation for the foreseeable future.

Principles in Financial Reporting (1 of 2)

Measurement Principles

Historical Cost

Or cost principle, dictates that companies record assets at their cost.

Fair Value

Indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

Full Disclosure Principle

Requires that companies disclose all circumstances and events that would make a difference to financial statement users.

Principles in Financial Reporting (2 of 2)

Cost Constraint

Accounting standard-setters weigh the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.

Do It! 3: Financial Accounting Concepts and Principles (1 of 4)

The following items guide the FASB when it creates accounting standards.

Relevance	Periodicity assumption
Faithful representation	Going concern assumption
Comparability	Historical cost principle
Consistency	Full disclosure principle
Monetary unit assumption	Materiality
Economic entity assumption	blank

Match each item above with a description below.

Ability to easily evaluate one company’s results relative to another’s.

Comparability

Belief that a company will continue to operate for the foreseeable future.

Going concern

The judgment concerning whether an item is large enough to matter to decision-makers

Materiality

Do It! 3: Financial Accounting Concepts and Principles (2 of 4)

The following items guide the FASB when it creates accounting standards.

Relevance	Periodicity assumption
Faithful representation	Going concern assumption
Comparability	Historical cost principle
Consistency	Full disclosure principle
Monetary unit assumption	Materiality
Economic entity assumption	blank

Match each item above with a description below.

The reporting of all information that would make a difference to financial statement users

Full disclosure

The practice of preparing financial statements at regular intervals.

Periodicity

The quality of information that indicates the information makes a difference in a decision.

Relevance

Do It! 3: Financial Accounting Concepts and Principles (3 of 4)

The following items guide the FASB when it creates accounting standards.

Relevance	Periodicity assumption
Faithful representation	Going concern assumption
Comparability	Historical cost principle
Consistency	Full disclosure principle
Monetary unit assumption	Materiality
Economic entity assumption	blank

Match each item above with a description below.

Belief that items should be reported on the balance sheet at the price that was paid to acquire the item.

Historical cost

A company’s use of the same accounting principles and methods from year to year.

Consistency

Tracing accounting events to particular companies.

Economic entity

Do It! 3: Financial Accounting Concepts and Principles (4 of 4)

The following items guide the FASB when it creates accounting standards.

Relevance	Periodicity assumption
Faithful representation	Going concern assumption
Comparability	Historical cost principle
Consistency	Full disclosure principle
Monetary unit assumption	Materiality
Economic entity assumption	blank

Match each item above with a description below.

The desire to minimize errors and bias in financial statements

Faithful representation

Reporting only those things that can be measured in dollars.

Monetary unit

The Standard-Setting Environment (3 of 4)

Review Question

What is the primary criterion by which accounting information can be judged?

a. Consistency.

b. Predictive value.

c. Usefulness for decision making.

d. Comparability.

The Standard-Setting Environment (4 of 4)

Review Question

What is the primary criterion by which accounting information can be judged?

a. Consistency.

b. Predictive value.

c. Usefulness for decision making.

d. Comparability.

A Look at I F R S- L O-4: Compare the Classified Balance Sheet Format Under GAAP and IFRS

Key Points

Similarities

I F R S generally requires a classified statement of financial position similar to the classified balance sheet under G A A P.

I F R S follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities.

A Look at I F R S (1 of 9)

Key Points

Differences

I F R S recommends but does not require the use of the title “statement of financial position” rather than balance sheet.

The format of statement of financial position information is often presented differently under I F R S. Although no specific format is required, many companies that follow IFRS present statement of financial position information in this order:

Non-current assets

Current assets

Equity

Non-current liabilities

Current liabilities

A Look at I F R S (2 of 9)

Key Points

Differences

Under I F R S, current assets are usually listed in the reverse order of liquidity. For example, under G A A P cash is listed first, but under IFRS it is listed last.

I F R S has many differences in terminology from what are shown in your textbook.

Both G A A P and I F R S are increasing the use of fair value to report assets. However, at this point I F R S has adopted it more broadly. As examples, under I F R S companies can apply fair value to property, plant, and equipment, and in some cases intangible assets.

A Look at I F R S (3 of 9)

Looking To The Future

The I A S B and the F A S B are working on a project to converge their standards related to financial statement presentation. A key feature of the proposed framework is that each of the statements will be organized in the same format, to separate an entity’s financing activities from its operating and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the income statement and the statement of cash flows. The project has three phases. You can follow the joint financial presentation project at the following link: http://ww.fasb.org/project/-financial_statement_presentation.shtml.

A Look at I F R S (4 of 9)

I F R S Practice

A company has purchased a tract of land and expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. Under I F R S, the land should be reported as:

a) land expense.

b) property, plant, and equipment.

c) an intangible asset.

d) a long-term investment.

A Look at I F R S (5 of 9)

I F R S Practice

a) land expense.

b) property, plant, and equipment.

c) an intangible asset.

d) a long-term investment.

A Look at I F R S (6 of 9)

I F R S Practice

Current assets under I F R S are listed generally:

a) by importance.

b) in the reverse order of their expected conversion to cash.

c) by longevity.

d) alphabetically.

A Look at I F R S (7 of 9)

I F R S Practice

Current assets under I F R S are listed generally:

a) by importance.

b) in the reverse order of their expected conversion to cash.

c) by longevity.

d) alphabetically.

A Look at I F R S (8 of 9)

I F R S Practice

Companies that use I F R S:

a) may report all their assets on the statement of financial position at fair value.

b) may offset assets against liabilities and show net assets and net liabilities on their statements of financial position, rather than the underlying detailed line items.

c) may report non-current assets before current assets on the statement of financial position.

d) do not have any guidelines as to what should be reported on the statement of financial position.

A Look at I F R S (9 of 9)

I F R S Practice

Companies that use I F R S:

a) may report all their assets on the statement of financial position at fair value.

b) may offset assets against liabilities and show net assets and net liabilities on their statements of financial position, rather than the underlying detailed line items.

c) may report non-current assets before current assets on the statement of financial position.

d) do not have any guidelines as to what should be reported on the statement of financial position.

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$26,000$2,000

$4.00

6,000

Working CapitalCurrent AssetsCurrent Lia

bilities

Free Cash Flow

Net Cash Provided by Operating Activites

Capital ExpendituresCash Dividends

$80000

(

)

(

)

$100,000$10,000

$1.00

120,00060,0002

2017

(

)

(

)

$50,000$10,000

$0.80

60,00040,0002

2016

$88,000

2.20:1

$40,000

2017

$60,800

1.60:1

$38,000

2016

$120,000

30%

$400,000

$150,000

44%

$341,000

$50,000

$37,500