Financial Statements Assignment

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A Further Look at Financial Statements

CHAPTER PREVIEW

If you are thinking of purchasing Best Buy stock, or any stock, how can you decide what the shares are worth? If you manage Columbia Sportswear's credit department, how should you determine whether to extend credit to a new customer? If you are a financial executive at Google, how do you decide whether your company is generating adequate cash to expand operations without borrowing? Your decision in each of these situations will be influenced by a variety of considerations. One of them should be your careful analysis of a company's financial statements. The reason: Financial statements offer relevant and reliable information, which will help you in your decision‐making.

In this chapter, we take a closer look at the balance sheet and introduce some useful ways for evaluating the information provided by the financial statements. We also examine the financial reporting concepts underlying the financial statements. We begin by introducing the classified balance sheet.

Just Fooling Around?

Few people could have predicted how dramatically the Internet would change the investment world. One of the most interesting results is how it has changed the way ordinary people invest their savings. More and more people are striking out on their own, making their own investment decisions.

Two early pioneers in providing investment information to the masses were Tom and David Gardner, brothers who created an online investor website called The Motley Fool. The name comes from Shakespeare's As You Like It. The fool in Shakespeare's play was the only one who could speak unpleasant truths to kings and queens without being killed. Tom and David view themselves as 21st‐century “fools,” revealing the “truths” of the stock market to the small investor, who they feel has been taken advantage of by Wall Street insiders. The Motley Fool's online bulletin board enables investors to exchange information and insights about companies.

Critics of these bulletin boards contend that they are simply high‐tech rumor mills that cause investors to bid up stock prices to unreasonable levels. For example, the stock of PairGain Technologies jumped 32% in a single day as a result of a bogus takeover rumor on an investment bulletin board. Some observers are concerned that small investors—ironically, the very people the Gardner brothers are trying to help—will be hurt the most by misinformation and intentional scams.

To show how these bulletin boards work, suppose that you had $10,000 to invest. You were considering Best Buy Company, the largest seller of electronics equipment in the United States. You scanned the Internet investment bulletin boards and found messages posted by two different investors. Here are excerpts from actual postings:

TMPVenus: “Where are the prospects for positive movement for this company? Poor margins, poor management, astronomical P/E!”

broachman: “I believe that this is a LONG TERM winner, and presently at a good price.”

One says sell, and one says buy. Whom should you believe? If you had taken “broachman's” advice and purchased the stock, the $10,000 you invested would have been worth over $300,000 five years later. Best Buy was one of America's best‐performing stocks during that period of time.

Rather than getting swept away by rumors, investors must sort out the good information from the bad. One thing is certain—as information services such as The Motley Fool increase in number, gathering information will become even easier. Evaluating it will be the harder task.

LEARNING OBJECTIVE 1

Identify the sections of a classified balance sheet.

In Chapter 1 , you learned that a balance sheet presents a snapshot of a company's financial position at a point in time. It lists individual asset, liability, and stockholders' equity items. However, to improve users' understanding of a company's financial position, companies often use a classified balance sheet instead. A classified balance sheet groups together similar assets and similar liabilities, using a number of standard classifications and sections. This is useful because items within a group have similar economic characteristics. A classified balance sheet generally contains the standard classifications listed in Illustration 2-1 .

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

ILLUSTRATION 2-1 Standard balance sheet classifications

These groupings help financial statement readers determine such things as (1) whether the company has enough assets to pay its debts as they come due, and (2) the claims of short‐ and long‐term creditors on the company's total assets. Many of these groupings can be seen in the balance sheet of Franklin Corporation shown in Illustration 2-2 . In the sections that follow, we explain each of these groupings.

FRANKLIN CORPORATION Balance Sheet October 31, 2017
Assets
Current assets
Cash		$ 6,600
Debt investments		2,000
Accounts receivable		7,000
Notes receivable		1,000
Inventory		3,000
Supplies		2,100
Prepaid insurance		400
Total current assets			$22,100
Long-term investments
Stock investments		5,200
Investment in real estate		2,000	7,200
Property, plant, and equipment
Land		10,000
Equipment	$24,000
Less: Accumulated depreciation—equipment	5,000	19,000	29,000
Intangible assets
Patents			3,100
Total assets			$61,400
Liabilities and Stockholders' Equity
Current liabilities
Notes payable		$11,000
Accounts payable		2,100
Unearned sales revenue		900
Salaries and wages payable		1,600
Interest payable		450
Total current liabilities			$16,050
Long-term liabilities
Mortgage payable		10,000
Notes payable		1,300
Total long-term liabilities			11,300
Total liabilities			27,350
Stockholders' equity
Common stock		14,000
Retained earnings		20,050
Total stockholders' equity			34,050
Total liabilities and stockholders' equity			$61,400

ILLUSTRATION 2-2 Classified balance sheet

▼ HELPFUL HINT

Recall that the accounting equation is Assets=Liabilities+Stockholders' EquityRecall that the accounting equation is Assets=Liabilities+Stockholders' Equity.

CURRENT ASSETS

Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2-2 , Franklin Corporation had current assets of $22,100. For most businesses, the cutoff for classification as current assets is one year from the balance sheet date. For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use the supplies in operations within one year.

Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year. The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers. For most businesses, this cycle takes less than a year, so they use a one‐year cutoff. But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long‐term.

Common types of current assets are (1) cash, (2) investments (such as short‐term U.S. government securities), (3) receivables (accounts receivable, notes receivable, and interest receivable), (4) inventories, and (5) prepaid expenses (insurance and supplies). Companies list current assets in the order in which they expect to convert them into cash. Follow this rule when doing your homework.

Illustration 2-3 presents the current assets of Southwest Airlines Co. in a recent year.

SOUTHWEST AIRLINES CO. Balance Sheet (partial) (in millions)
Current assets
Cash and cash equivalents	$1,355
Short-term investments	1,797
Accounts receivable	419
Inventories	467
Prepaid expenses and other current assets	418
Total current assets	$4,456

ILLUSTRATION 2-3 Current assets section

As explained later in the chapter, a company's current assets are important in assessing its short‐term debt‐paying ability.

LONG‐TERM INVESTMENTS

Long‐term investments are generally (1) investments in stocks and bonds of other corporations that are held for more than one year, (2) long‐term assets such as land or buildings that a company is not currently using in its operating activities, and (3) long‐term notes receivable. In Illustration 2-2 , Franklin Corporation reported total long‐term investments of $7,200 on its balance sheet.

Google Inc. reported long‐term investments on its balance sheet in a recent year as shown in Illustration 2-4 .

GOOGLE INC.

Balance Sheet (partial)

(in millions)

Long-term investments

Non-marketable equity investments

$1,469

ILLUSTRATION 2-4 Long‐term investments section

ALTERNATIVE TERMINOLOGY

Long‐term investments are often referred to simply as investments.

PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business. This category includes land, buildings, equipment, delivery vehicles, and furniture. In Illustration 2-2 , Franklin Corporation reported property, plant, and equipment of $29,000.

Depreciation is the allocation of the cost of an asset to a number of years. Companies do this by systematically assigning a portion of an asset's cost as an expense each year (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset's life. In Illustration 2-2 , Franklin Corporation reported accumulated depreciation of $5,000.

Illustration 2-5 presents the property, plant, and equipment of Tesla Motors, Inc. in a recent year.

TESLA MOTORS, INC. Balance Sheet (partial) (in thousands)
Property, plant, and equipment
Machinery, equipment and office furniture	$ 322,394
Tooling	230,385
Leasehold improvements	94,763
Building and building improvements	67,707
Land	45,020
Computer equipment and software	42,073
Construction in progress	76,294
	878,636
Less: Accumulated depreciation and amortization	(140,142)
Total	$ 738,494

ILLUSTRATION 2-5 Property, plant, and equipment section

ALTERNATIVE TERMINOLOGY

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

INTANGIBLE ASSETS

Many companies have assets that do not have physical substance and yet often are very valuable. We call these assets intangible assets . One common intangible is goodwill. Others include patents, copyrights, and trademarks or trade names that give the company exclusive right of use for a specified period of time. In Illustration 2-2 , Franklin Corporation reported intangible assets of $3,100.

Illustration 2-6 shows the intangible assets of media and theme park giant The Walt Disney Company in a recent year.

THE WALT DISNEY COMPANY Balance Sheet (partial) (in millions)
Intangible assets and goodwill
Character/franchise intangibles and copyrights		$ 5,830
Other amortizable intangible assets		903
Accumulated amortization		(1,204)
Net amortizable intangible assets		5,529
FCC licenses		667
Trademarks		1,218
Other indefinite lived intangible assets		20
		7,434
Goodwill		27,881
		$35,315

ILLUSTRATION 2-6 Intangible assets section

DO IT! 1a

Assets Section of Classified Balance Sheet

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

Prepaid insurance	$ 2,300	Inventory	$3,400
Cash	800	Accumulated depreciation—equipment	2,700
Equipment	10,700	Accounts receivable	1,100

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

Action Plan

✓ Present current assets first. Current assets are cash and other resources that the company expects to convert to cash or use up within one year.

✓ Present current assets in the order in which the company expects to convert them into cash.

✓ Subtract accumulated depreciation—equipment from equipment to determine net equipment.

SOLUTION

HOFFMAN CORPORATION Balance Sheet (partial) December 31, 2017
Assets
Current assets
Cash	$ 800
Accounts receivable	1,100
Inventory	3,400
Prepaid insurance	2,300
Total current assets		$ 7,600
Property, plant, and equipment
Equipment	10,700
Less: Accumulated depreciation—equipment	2,700	8,000
Total assets		$15,600

Related exercise material: BE2-2, DO IT! 2-1a, E2-3, and E2-4.

▼ HELPFUL HINT

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

CURRENT LIABILITIES

In the liabilities and stockholders' equity section of the balance sheet, the first grouping is current liabilities. Current liabilities are obligations that 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. In Illustration 2-2 , Franklin Corporation reported five different types of current liabilities, for a total of $16,050.

Illustration 2-7 shows the current liabilities section adapted from the balance sheet of Google Inc. in a recent year.

GOOGLE INC. Balance Sheet (partial) (in millions)
Current liabilities
Accounts payable	$ 2,012
Short-term debt	2,549
Accrued compensation and benefits	2,239
Accrued expenses and other current liabilities	7,297
Income taxes payable, net	240
Total current liabilities	$14,337

ILLUSTRATION 2-7 Current liabilities section

LONG‐TERM LIABILITIES

Long‐term liabilities (long‐term debt) are obligations that a company expects to pay after one year. Liabilities in this category include bonds payable, mortgages payable, long‐term notes payable, lease liabilities, and pension liabilities. Many companies report long‐term debt maturing after one year as a single amount in the balance sheet and show the details of the debt in notes that accompany the financial statements. Others list the various types of long‐term liabilities. In Illustration 2-2 , Franklin Corporation reported long‐term liabilities of $11,300.

Illustration 2-8 shows the long‐term liabilities that Nike, Inc. reported in its balance sheet in a recent year.

NIKE, INC. Balance Sheet (partial) (in millions)
Long-term liabilities
Bonds payable		$1,106
Notes payable		51
Deferred income taxes and other		1,544
Total long-term liabilities		$2,701

ILLUSTRATION 2-8 Long‐term liabilities section

STOCKHOLDERS' EQUITY

Stockholders' equity consists of two parts: common stock and retained earnings. Companies record as common stock the investments of assets into the business by the stockholders. They record as retained earnings the income retained for use in the business. These two parts, combined, make up stockholders' equity on the balance sheet. In Illustration 2-2 , Franklin Corporation reported common stock of $14,000 and retained earnings of $20,050.

ALTERNATIVE TERMINOLOGY

Common stock is sometimes called capital stock.

DO IT! 1b

Balance Sheet Classifications

The following financial statement items were taken from the financial statements of Callahan Corp.

1. ________ Salaries and wages payable

2. ________ Service revenue

3. ________ Interest payable

4. ________ Goodwill

5. ________ Debt investments (short‐term)

6. ________ Mortgage payable (due in 3 years)

7. ________ Investment in real estate

8. ________ Equipment

9. ________ Accumulated depreciation—equipment

10. ________ Depreciation expense

11. ________ Retained earnings

12. ________ Unearned service revenue

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.”

1. Current assets (CA)

2. Long‐term investments (LTI)

3. Property, plant, and equipment (PPE)

4. Intangible assets (IA)

5. Current liabilities (CL)

6. Long‐term liabilities (LTL)

7. Stockholders' equity (SE)

Action Plan

✓ Analyze whether each financial statement item is an asset, liability, or stockholders' equity item.

✓ Determine if asset and liability items are current or long‐term.

SOLUTION

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

Related exercise material: BE2-1, DO IT! 2-1b, E2-1, E2-2, E2-3, E2-5, and E2-6.

LEARNING OBJECTIVE 2

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

In Chapter 1 , we introduced the four financial statements. We discussed how these statements provide information about a company's performance and financial position. In this chapter, we extend this discussion by showing you specific tools that you can use to analyze financial statements in order to make a more meaningful evaluation of a company.

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. For analysis of the primary financial statements, we classify ratios as shown in Illustration 2-9 .

ILLUSTRATION 2-9 Financial ratio classifications

A single ratio by itself is not very meaningful. Accordingly, in this and the following chapters, we will use various comparisons to shed light on company performance:

1. Intracompany comparisons covering two years for the same company.

2. Industry‐average comparisons based on average ratios for particular industries.

3. Intercompany comparisons based on comparisons with a competitor in the same industry.

Next, we use some ratios and comparisons to analyze the financial statements of Best Buy.

USING THE INCOME STATEMENT

Best Buy generates profits for its stockholders by selling electronics. The income statement reveals how successful the company is at generating a profit from its sales. The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses). Illustration 2-10 shows a simplified income statement for Best Buy.

BEST BUY CO., INC. Income Statements For the 12 Months Ended February 1, 2014, and 11 Months Ended February 2, 2013 (in millions)
	2014	2013
Revenues
Net sales and other revenue	$42,410	$39,827
Expenses
Cost of goods sold	32,720	30,528
Selling, general, and administrative expenses and other	8,760	9,471
Income tax expense	398	269
Total expenses	41,878	40,268
Net income/(loss)	$ 532	$ (441)

ILLUSTRATION 2-10 Best Buy's income statement

From this income statement, we can see that Best Buy's sales and net income increased during the period. Net income increased from a $441 million loss to a positive $532 million. One extremely unusual aspect of Best Buy's income statement is that the 2013 comparative column only covers 11 months. This occurred because Best Buy changed its year‐end from “the Saturday nearest the end of February to the Saturday nearest the end of January.” Such a change is very uncommon and complicates efforts to compare performance across years.

A much smaller competitor of Best Buy is hhgregg. hhgregg operates 228 stores in 20 states and is headquartered in Indianapolis, Indiana. It reported net income of $228,000 for the year ended March 31, 2014.

To evaluate the profitability of Best Buy, we will use ratio analysis. Profitability ratios , such as earnings per share, measure the operating success of a company for a given period of time.

Earnings per Share

Earnings per share (EPS) measures the net income earned on each share of common stock. Stockholders usually think in terms of the number of shares they own or plan to buy or sell, so stating net income earned as a per share amount provides a useful perspective for determining the investment return. Advanced accounting courses present more refined techniques for calculating earnings per share.

For now, a basic approach for calculating earnings per share is to divide earnings available to common stockholders by weighted‐average common shares outstanding during the year. What is “earnings available to common stockholders”? It is an earnings amount calculated as net income less dividends paid on another type of stock, called preferred stock (Net income−Preferred dividends)(Net income−Preferred dividends).

DECISION TOOLS

Earnings per share helps users compare a company's performance with that of previous years.

By comparing earnings per share of a single company over time, we can evaluate its relative earnings performance from the perspective of a stockholder—that is, on a per share basis. It is very important to note that comparisons of earnings per share across companies are not meaningful because of the wide variations in the numbers of shares of outstanding stock among companies.

Illustration 2-11 shows the earnings per share calculation for Best Buy in 2014 and 2013, based on the information presented below. Recall that Best Buy's 2013 income is based on 11 months of results. Further, to simplify our calculations, we assumed that any change in the number of shares for Best Buy occurred in the middle of the year.

(in millions)	2014	2013
Net income (loss)	$532	$(441)
Preferred dividends	–0–	–0–
Shares outstanding at beginning of year	338	341
Shares outstanding at end of year	347	338

ILLUSTRATION 2-11 Best Buy's earnings per share

USING A CLASSIFIED BALANCE SHEET

You can learn a lot about a company's financial health by also evaluating the relationship between its various assets and liabilities. Illustration 2-12 provides a simplified balance sheet for Best Buy.

BEST BUY CO., INC. Balance Sheets (in millions)
Assets	February 1, 2014	February 2, 2013
Current assets
Cash and cash equivalents	$ 2,678	$ 1,826
Short-term investments	223	0
Receivables	1,308	2,704
Merchandise inventories	5,376	6,571
Other current assets	900	946
Total current assets	10,485	12,047
Property and equipment	7,575	8,375
Less: Accumulated depreciation	4,977	5,105
Net property and equipment	2,598	3,270
Other assets	930	1,470
Total assets	$14,013	$16,787
Liabilities and Stockholders' Equity
Current liabilities
Accounts payable	$ 5,122	$ 6,951
Accrued liabilities	873	1,188
Accrued income taxes	147	129
Accrued compensation payable	444	520
Other current liabilities	850	2,022
Total current liabilities	7,436	10,810
Long-term liabilities
Long-term debt	976	1,109
Other long-term liabilities	1,612	1,153
Total long-term liabilities	2,588	2,262
Total liabilities	10,024	13,072
Stockholders' equity
Common stock	335	88
Retained earnings and other	3,654	3,627
Total stockholders' equity	3,989	3,715
Total liabilities and stockholders' equity	$14,013	$16,787

ILLUSTRATION 2-12 Best Buy's balance sheet

Liquidity

Suppose you are a banker at CitiGroup considering lending money to Best Buy, or you are a sales manager at Hewlett‐Packard interested in selling computers to Best Buy on credit. You would be concerned about Best Buy's liquidity —its ability to pay obligations expected to become due within the next year or operating cycle. You would look closely at the relationship of its current assets to current liabilities.

WORKING CAPITAL One measure of liquidity is working capital , which is the difference between the amounts of current assets and current liabilities:

Working Capital=Current Assets−Current LiabilitiesWorking Capital=Current Assets−Current Liabilities

ILLUSTRATION 2-13 Working capital

When current assets exceed current liabilities, working capital is positive. When this occurs, there is a greater likelihood that the company will pay its liabilities. When working capital is negative, a company might not be able to pay short‐term creditors, and the company might ultimately be forced into bankruptcy. Best Buy had working capital in 2014 of $3,049 million ($10,485 million−$7,436 million)($10,485 million−$7,436 million).

CURRENT RATIO Liquidity ratios measure the short‐term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. One liquidity ratio is the current ratio , computed as current assets divided by current liabilities.

DECISION TOOLS

The current ratio helps users determine if a company can meet its near‐term obligations.

The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have significantly different current ratios. Illustration 2-14 shows the 2014 and 2013 current ratios for Best Buy and for hhgregg, along with the 2014 industry average.

ILLUSTRATION 2-14 Current ratio

What does the ratio actually mean? Best Buy's 2014 current ratio of 1.41:1 means that for every dollar of current liabilities, Best Buy has $1.41 of current assets. Best Buy's current ratio increased in 2014. When compared to the industry average of .88:1, Best Buy's liquidity seems strong. It is lower than hhgregg's but not significantly so.

One potential weakness of the current ratio is that it does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose whether a portion of the current assets is tied up in slow‐moving inventory. The composition of the current assets matters because a dollar of cash is more readily available to pay the bills than is a dollar of inventory. For example, suppose a company's cash balance declined while its merchandise inventory increased substantially. If inventory increased because the company is having difficulty selling its products, then the current ratio might not fully reflect the reduction in the company's liquidity.

ETHICS NOTE

A company that has more current assets than current liabilities can increase the ratio of current assets to current liabilities by using cash to pay off some current liabilities. This gives the appearance of being more liquid. Do you think this move is ethical?

ACCOUNTING ACROSS THE ORGANIZATION

REL Consultancy Group

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).

What can various company managers do to ensure that working capital is managed efficiently to maximize net income? (Go to WileyPLUS for this answer and additional questions.)

Solvency

Now suppose that instead of being a short‐term creditor, you are interested in either buying Best Buy's stock or extending the company a long‐term loan. Long‐term creditors and stockholders are interested in a company's solvency —its 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.

DEBT TO ASSETS RATIO The debt to assets ratio is one measure of solvency. It is calculated by dividing total liabilities (both current and long‐term) by total assets. It measures the percentage of total financing provided by creditors rather than stockholders. Debt financing is more risky than equity financing because debt must be repaid at specific points in time, whether the company is performing well or not. Thus, the higher the percentage of debt financing, the riskier the company.

▼ 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.

The higher the percentage of total liabilities (debt) to total assets, the greater the risk that the company may be unable to pay its debts as they come due. Illustration 2-15 shows the debt to assets ratios for Best Buy and hhgregg, along with the industry average.

ILLUSTRATION 2-15 Debt to assets ratio

The 2014 ratio of 72% means that every dollar of assets was financed by 72 cents of debt. Best Buy's ratio is less than the industry average of 88% and is significantly higher than hhgregg's ratio of 51%. The higher the ratio, the more reliant the company is on debt financing. This means that Best Buy has a lower equity “buffer” available to creditors if the company becomes insolvent when compared to hhgregg. Thus, from the creditors' point of view, a high ratio of debt to assets is undesirable. Best Buy's solvency appears lower than hhgregg's and higher than the average company in the industry.

The adequacy of this ratio is often judged in light of the company's earnings. Generally, companies with relatively stable earnings, such as public utilities, can support higher debt to assets ratios than can cyclical companies with widely fluctuating earnings, such as many high‐tech companies. In later chapters, you will learn additional ways to evaluate solvency.

DECISION TOOLS

The debt to assets ratio helps users determine if a company can meet its long‐term obligations.

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:

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

Discuss the difference in the debt to assets ratio of Microsoft and General Motors. (Go to WileyPLUS for this answer and additional questions.)

USING THE STATEMENT OF CASH FLOWS

In the statement of cash flows, net cash provided by operating activities is intended to indicate the cash‐generating capability of the company. Analysts have noted, however, that net cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment (capital expenditures) just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. A measurement to provide additional insight regarding a company's cash‐generating ability is free cash flow. Free cash flow describes the net cash provided by operating activities after adjusting for capital expenditures and dividends paid.

Consider the following example. Suppose that MPC produced and sold 10,000 personal computers this year. It reported $100,000 net 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. Its free cash flow was $80,000 ($100,000−$15,000−$5,000)$80,000 ($100,000−$15,000−$5,000). The company could use this $80,000 to purchase new assets to expand the business, pay off debts, or increase its dividend distribution. In practice, analysts often calculate free cash flow with the formula shown in Illustration 2-16 . (Alternative definitions also exist.)

DECISION TOOLS

Free cash flow helps users determine the amount of cash a company generated to expand operations, pay off debts, or increase dividends.

Free CashFlow=Net Cash Providedby Operating Activities−CapitalExpenditures−CashDividendsFree CashFlow=Net Cash Providedby Operating Activities−CapitalExpenditures−CashDividends

ILLUSTRATION 2-16 Free cash flow

We can calculate Best Buy's 2014 free cash flow as shown in Illustration 2-17 (dollars in millions).

Net cash provided by operating activities	$1,094
Less: Expenditures on property, plant, and equipment	547
Dividends paid	233
Free cash flow	$ 314

ILLUSTRATION 2-17 Best Buy's free cash flow

Best Buy generated free cash flow of $314 million, which is available for the acquisition of new assets, the retirement of stock or debt, or the payment of additional dividends. Long‐term creditors consider a high free cash flow amount an indication of solvency. hhgregg's free cash flow for 2014 is $60 million. Given that hhgregg is considerably smaller than Best Buy, we would expect its free cash flow to be much lower.

DO IT! 2

Ratio Analysis

The following information is available for Ozone Inc.

	2017	2016
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 property, plant, and equipment	45,000	20,000
Shares outstanding at beginning of year	60,000	40,000
Shares outstanding at end of year	120,000	60,000

(a) Compute earnings per share for 2017 and 2016 for Ozone, and comment on the change. Ozone's primary competitor, Frost Corporation, had earnings per share of $2 in 2017. Comment on the difference in the ratios of the two companies.

(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.

Action Plan

✓ Use the formula for earnings per share (EPS): (Net income−Preferred dividends)÷Weighted‐average common shares outstanding(Net income−Preferred dividends)÷Weighted‐average common shares outstanding.

✓ Use the formula for the current ratio: Current assets÷Current liabilitiesCurrent assets÷Current liabilities.

✓ Use the formula for the debt to assets ratio: Total liabilities÷Total assetsTotal liabilities÷Total assets.

✓ Use the formula for free cash flow: Net cash provided by operating activities−Capital expenditures−Cash dividendsNet cash provided by operating activities−Capital expenditures−Cash dividends.

SOLUTION

(a) Earnings per share

2017		2016
($100,000−$10,000)(120,000+60,000)/2=$1.00($100,000−$10,000)(120,000+60,000)/2=$1.00		($50,000−$10,000)(60,000+40,000)/2=$0.80($50,000−$10,000)(60,000+40,000)/2=$0.80

Ozone's profitability, as measured by the amount of income available to each share of common stock, increased by 25% [($1.00−$0.80)÷$0.80]25% [($1.00−$0.80)÷$0.80] during 2017. Earnings per share should not be compared across companies because the number of shares issued by companies varies widely. Thus, we cannot conclude that Frost Corporation is more profitable than Ozone based on its higher EPS.

(b)

	2017	2016
Current ratio	$88,000$40,000=2.20:1$88,000$40,000=2.20:1	$60,800$38,000=1.60:1$60,800$38,000=1.60:1
Debt to assets ratio	$120,000$400,000=30%$120,000$400,000=30%	$150,000$341,000=44%$150,000$341,000=44%

The company's liquidity, as measured by the current ratio, improved from 1.60:1 to 2.20:1. Its solvency also improved, as measured by the debt to assets ratio, which declined from 44% to 30%.

2017:$110,000−$45,000−($10,000+$5,000)=$50,0002016:$70,000−$20,000−($10,000+$2,500)=$37,5002017:$110,000−$45,000−($10,000+$5,000)=$50,0002016:$70,000−$20,000−($10,000+$2,500)=$37,500

The amount of cash generated by the company above its needs for dividends and capital expenditures increased from $37,500 to $50,000.

Related exercise material: BE2-3, BE2-4, BE2-5, DO IT! 2-2, E2-7, E2-9, E2-10, and E2-11.

LEARNING OBJECTIVE 3

Discuss financial reporting concepts.

You have now learned about the four financial statements and some basic ways to interpret those statements. In this last section, we will discuss concepts that underlie these financial statements. It would be unwise to make business decisions based on financial statements without understanding the implications of these concepts.

THE STANDARD‐SETTING ENVIRONMENT

How does Best Buy decide on the type of financial information to disclose? What format should it use? How should it measure assets, liabilities, revenues, and expenses? Accounting professionals at Best Buy and all other U.S. companies get guidance from a set of accounting standards that have authoritative support, referred to as generally accepted accounting principles (GAAP) . Standard‐setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards.

The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. financial markets and accounting standard‐setting bodies. The Financial Accounting Standards Board (FASB) is the primary accounting standard‐setting body in the United States. The International Accounting Standards Board (IASB) issues standards called International Financial Reporting Standards (IFRS) , which have been adopted by many countries outside of the United States. Today, the FASB and IASB are working closely together to minimize the differences in their standards. Recently, the SEC announced that foreign companies that wish to have their shares traded on U.S stock exchanges no longer have to prepare reports that conform with GAAP, as long as their reports conform with IFRS. The SEC is currently evaluating whether the United States should eventually adopt IFRS as the required set of standards for U.S. publicly traded companies. Another relatively recent change to the financial reporting environment was that, as a result of the Sarbanes‐Oxley Act, the Public Company Accounting Oversight Board (PCAOB) was created. Its job is to determine auditing standards and review the performance of auditing firms. If the United States adopts IFRS for its accounting standards, it will also have to coordinate its auditing regulations with those of other countries.

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).

What is meant by the phrase “make the country's businesses more transparent”? Why would increasing transparency spur economic growth? (Go to WileyPLUS for this answer and additional questions.)

INTERNATIONAL NOTE

Over 115 countries use international standards (called IFRS). For example, all companies in the European Union follow IFRS. In this textbook, we highlight any significant differences using International Notes like this one, as well as a more in‐depth discussion in the A Look at IFRS section at the end of each chapter.

QUALITIES OF USEFUL INFORMATION

Recently, the FASB and IASB completed the first phase of a joint project in which they developed a conceptual framework to serve as the basis for future accounting standards. The framework begins by stating that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 2-18 (page 60).

	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.

	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.

ILLUSTRATION 2-18 Fundamental qualities of useful information

Enhancing Qualities

In addition to the two fundamental qualities, the FASB and IASB also describe a number of enhancing qualities of useful information. These include comparability, verifiability, timeliness, and understandability. In accounting, comparability results when different companies use the same accounting principles. Another type of comparability is consistency. Consistency means that a company uses the same accounting principles and methods from year to year. Information is verifiable if independent observers, using the same methods, obtain similar results. As noted in Chapter 1 , certified public accountants (CPAs) perform audits of financial statements to verify their accuracy. For accounting information to have relevance, it must be timely . That is, it must be available to decision‐makers before it loses its capacity to influence decisions. The SEC requires that large public companies provide their annual reports to investors within 60 days of their year‐end. Information has the quality of understandability if it is presented in a clear and concise fashion, so that reasonably informed users of that information can interpret it and comprehend its meaning.

ACCOUNTING ACROSS THE ORGANIZATION

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.

What problems might Best Buy's year‐end create for analysts? (Go to WileyPLUS for this answer and additional questions.)

ASSUMPTIONS IN FINANCIAL REPORTING

To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 2-19 . These include assumptions about the monetary unit, economic entity, periodicity, and going concern.

	Monetary Unit Assumption The monetary unit assumption requires that only those things that can be expressed in money are included in the accounting records. This means that certain important information needed by investors, creditors, and managers, such as customer satisfaction, is not reported in the financial statements. This assumption relies on the monetary unit remaining relatively stable in value.

	Economic Entity Assumption The economic entity assumption states that every economic entity can be separately identified and accounted for. In order to assess a company's performance and financial position accurately, it is important to not blur company transactions with personal transactions (especially those of its managers) or transactions of other companies.

	Periodicity Assumption Notice that the income statement, retained earnings statement, and statement of cash flows all cover periods of one year, and the balance sheet is prepared at the end of each year. The periodicity assumption states that the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business.

	Going Concern Assumption The going concern assumption states that the business will remain in operation for the foreseeable future. Of course, many businesses do fail, but in general it is reasonable to assume that the business will continue operating.

ILLUSTRATION 2-19 Key assumptions in financial reporting

ETHICS NOTE

The importance of the economic entity assumption is illustrated by scandals involving Adelphia. In this case, senior company employees entered into transactions that blurred the line between the employees' financial interests and those of the company. For example, Adelphia guaranteed over $2 billion of loans to the founding family.

PRINCIPLES IN FINANCIAL REPORTING

Measurement Principles

GAAP generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade‐offs between relevance and faithful representation.

HISTORICAL COST PRINCIPLE The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. For example, if land that was purchased for $30,000 increases in value to $40,000, it continues to be reported at $30,000.

FAIR VALUE PRINCIPLE The fair value principle indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets. In choosing between cost and fair value, the FASB uses two qualities that make accounting information useful for decision‐making—relevance and faithful representation. In determining which measurement principle to use, the FASB weighs the factual nature of cost figures versus the relevance of fair value. In general, the FASB indicates that most assets must follow the historical cost principle because market values may not be representationally faithful. Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied.

Full Disclosure Principle

The full disclosure principle requires that companies disclose all circumstances and events that would make a difference to financial statement users. If an important item cannot reasonably be reported directly in one of the four types of financial statements, then it should be discussed in notes that accompany the statements.

COST CONSTRAINT

Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard‐setters consider the cost constraint . It weighs 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

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

Match each item above with a description below.

1. ________ Ability to easily evaluate one company's results relative to another's.

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

3. ________ The judgment concerning whether an item is large enough to matter to decision‐makers.

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

5. ________ The practice of preparing financial statements at regular intervals.

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

7. ________ A belief that items should be reported on the balance sheet at the price that was paid to acquire the item.

8. ________ A company's use of the same accounting principles and methods from year to year.

9. ________ Tracing accounting events to particular companies.

10. ________ The desire to minimize errors and bias in financial statements.

11. ________ Reporting only those things that can be measured in dollars.

Action Plan

✓ Understand the need for conceptual guidelines in accounting.

✓ List the characteristics of useful financial information.

✓ Review the assumptions, principles, and constraint that comprise the guidelines in accounting.

SOLUTION

1. Comparability

2. Going concern assumption

3. Materiality

4. Full disclosure principle

5. Periodicity assumption

6. Relevance

7. Historical cost principle

8. Consistency

9. Economic entity assumption

10. Faithful representation

11. Monetary unit assumption

Related exercise material: BE2-8, BE2-9, BE2-10, DO IT! 2-3, E2-12, and E2-13.

USING DECISION TOOLS—TWEETER HOME ENTERTAINMENT

In this chapter, we evaluated a home electronics giant, Best Buy. Tweeter Home Entertainment sold consumer electronics products from 154 stores on the East Coast under various names. It specialized in products with high‐end features. Tweeter filed for bankruptcy in June 2007 and was acquired by another company in July 2007. Financial data for Tweeter, prior to its bankruptcy, are provided below.

	September 30
(amounts in millions)	2006	2005
Current assets	$146.4	$158.2
Total assets	258.6	284.0
Current liabilities	107.1	119.0
Total liabilities	190.4	201.1
Total common stockholders' equity	68.2	82.9
Net income (loss)	(16.5)	(74.4)
Net cash provided (used) by operating activities	15.6	(26.7)
Capital expenditures (net)	17.4	22.2
Dividends paid	0	0
Weighted-average shares of common stock (millions)	25.2	24.6

INSTRUCTIONS

Using the data provided, answer the following questions and discuss how these results might have provided an indication of Tweeter's financial troubles.

1. Calculate the current ratio for Tweeter for 2006 and 2005 and discuss its liquidity position.

2. Calculate the debt to assets ratio and free cash flow for Tweeter for 2006 and 2005 and discuss its solvency.

3. Calculate the earnings per share for Tweeter for 2006 and 2005, and discuss its change in profitability.

4. Best Buy's accounting year‐end was February 28, 2006; Tweeter's was September 30, 2006. How does this difference affect your ability to compare their profitability?

SOLUTION

1. Current ratio:

2006:$146.4÷$107.1=1.37:12005:$158.2÷$119.0=1.33:12006:$146.4÷$107.1=1.37:12005:$158.2÷$119.0=1.33:1

Tweeter's liquidity improved slightly from 2005 to 2006, but in both years it would most likely have been considered inadequate. In 2006, Tweeter had only $1.37 in current assets for every dollar of current liabilities. Sometimes larger companies, such as Best Buy, can function with lower current ratios because they have alternative sources of working capital. But a company of Tweeter's size would normally want a higher ratio.

2. Debt to assets ratio:

2006:$190.4÷$258.6=73.6%2005:$201.1÷$284.0=70.8%2006:$190.4÷$258.6=73.6%2005:$201.1÷$284.0=70.8%

Tweeter's solvency, as measured by its debt to assets ratio, declined from 2005 to 2006. Its ratio of 73.6% meant that every dollar of assets was financed by 73.6 cents of debt. For a retailer, this is extremely high reliance on debt. This low solvency suggests Tweeter's ability to meet its debt payments was questionable.

Free cash flow:

2006:$15.6−$17.4−$0=−$1.8 million2005:−$26.7−$22.2−$0=−$48.9 million2006:$15.6−$17.4−$0=−$1.8 million2005:−$26.7−$22.2−$0=−$48.9 million

Tweeter's free cash flow was negative in both years. The company did not generate enough net cash provided by operating activities even to cover its capital expenditures, and it was not paying a dividend. While this is not unusual for new companies in their early years, it is also not sustainable for very long. Part of the reason that its debt to assets ratio, discussed above, was so high was that it had to borrow money to make up for its deficient free cash flow.

3. Loss per share:

2006:−$16.5÷$25.2=−$0.65 per share2005:−$74.4÷$24.6=−$3.02 per share2006:−$16.5÷$25.2=−$0.65 per share2005:−$74.4÷$24.6=−$3.02 per share

Tweeter's loss per share declined substantially. However, this was little consolation for its shareholders, who experienced losses in previous years as well. The company's lack of profitability, combined with its poor liquidity and solvency, increased the likelihood that it would eventually file for bankruptcy.

4. Tweeter's income statement covers 7 months not covered by Best Buy's. Suppose that the economy changed dramatically during this 7‐month period, either improving or declining. This change in the economy would be reflected in Tweeter's income statement but would not be reflected in Best Buy's income statement until the following March, thus reducing the usefulness of a comparison of the income statements of the two companies.

REVIEW AND PRACTICE

LEARNING OBJECTIVES REVIEW

1. Identify the sections of a classified balance sheet. In a classified balance sheet, companies classify assets as current assets; long‐term investments; property, plant, and equipment; and intangibles. They classify liabilities as either current or long‐term. A stockholders' equity section shows common stock and retained earnings.

2. Use ratios to evaluate a company's profitability, liquidity, and solvency. Ratio analysis expresses the relationship among selected items of financial statement data. Profitability ratios, such as earnings per share (EPS), measure aspects of the operating success of a company for a given period of time.

Liquidity ratios, such as the current ratio, measure the short‐term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. Solvency ratios, such as the debt to assets ratio, measure the ability of a company to survive over a long period. Free cash flow indicates a company's ability to generate net cash provided by operating activities that is sufficient to pay debts, acquire assets, and distribute dividends.

3. Discuss financial reporting concepts. Generally accepted accounting principles are a set of rules and practices recognized as a general guide for financial reporting purposes. The basic objective of financial reporting is to provide information that is useful for decision‐making.

To be judged useful, information should have the primary characteristics of relevance and faithful representation. In addition, useful information is com parable, consistent, verifiable, timely, and understandable.

The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption states that economic events can be identified with a particular unit of accountability. The periodicity assumption states that the economic life of a business can be divided into artificial time periods and that meaningful accounting reports can be prepared for each period. The going concern assumption states that the company will continue in operation long enough to carry out its existing objectives and commitments.

The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The full disclosure principle requires that companies disclose circumstances and events that matter to financial statement users.

The cost constraint weighs the cost that companies incur to provide a type of information against its benefit to financial statement users.

DECISION TOOLS REVIEW

DECISION CHECKPOINTS	INFO NEEDED FOR DECISION	TOOL TO USE FOR DECISION	HOW TO EVALUATE RESULTS
How does the company's earnings performance compare with that of previous years?	Net income available to common stockholders and weighted-average common shares outstanding	Earnings per share=Net income−Preferred dividendsWeighted-average common shares outstandingEarnings per share=Net income−Preferred dividendsWeighted-average common shares outstanding	A higher measure suggests improved performance, although the number is subject to manipulation. Values should not be compared across companies.
Can the company meet its near-term obligations?	Current assets and current liabilities	Current ratio=Current assetsCurrent liabilitiesCurrent ratio=Current assetsCurrent liabilities	Higher ratio suggests favorable liquidity.
Can the company meet its long-term obligations?	Total liabilities and total assets	Debt to assets ratio=Total liabilitiesTotal assetsDebt to assets ratio=Total liabilitiesTotal assets	Lower value suggests favorable solvency.
How much cash did the company generate to expand operations, pay off debts, or distribute dividends?	Net cash provided by operating activities, cash spent on fixed assets, and cash dividends	Free cash flow=Net cash provided by operating activites−Capital expenditures−Cash dividendsFree cash flow=Net cash provided by operating activites−Capital expenditures−Cash dividends	Significant free cash flow indicates greater potential to finance new investments and pay additional dividends.

GLOSSARY REVIEW

· Classified balance sheet A balance sheet that groups together similar assets and similar liabilities, using a number of standard classifications and sections.

· Comparability Ability to compare the accounting information of different companies because they use the same accounting principles.

· Consistency Use of the same accounting principles and methods from year to year within a company.

· Cost constraint Constraint that weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.

· Current assets Assets that companies expect to convert to cash or use up within one year or the operating cycle, whichever is longer.

· Current liabilities Obligations that a company expects to pay within the next year or operating cycle, whichever is longer.

· Current ratio A measure of liquidity computed as current assets divided by current liabilities.

· Debt to assets ratio A measure of solvency calculated as total liabilities divided by total assets. It measures the percentage of total financing provided by creditors.

· Earnings per share (EPS) A measure of the net income earned on each share of common stock; computed as net income minus preferred dividends divided by the weighted‐average number of common shares outstanding during the year.

· Economic entity assumption An assumption that every economic entity can be separately identified and accounted for.

· Fair value principle Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

· Faithful representation Information that is complete, neutral, and free from error.

· Financial Accounting Standards Board (FASB) The primary accounting standard‐setting body in the United States.

· Free cash flow Net cash provided by operating activities after adjusting for capital expenditures and cash dividends paid.

· Full disclosure principle Accounting principle that dictates that companies disclose circumstances and events that make a difference to financial statement users.

· Generally accepted accounting principles (GAAP) A set of accounting standards that have substantial authoritative support and which guide accounting professionals.

· Going concern assumption The assumption that the company will continue in operation for the foreseeable future.

· Historical cost principle An accounting principle that states that companies should record assets at their cost.

· Intangible assets Assets that do not have physical substance.

· International Accounting Standards Board (IASB) An accounting standard‐setting body that issues standards adopted by many countries outside of the United States.

· International Financial Reporting Standards (IFRS) Accounting standards, issued by the IASB, that have been adopted by many countries outside of the United States.

· Liquidity The ability of a company to pay obligations that are expected to become due within the next year or operating cycle.

· Liquidity ratios Measures of the short‐term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

· Long‐term investments Generally, (1) investments in stocks and bonds of other corporations that companies hold for more than one year; (2) long‐term assets, such as land and buildings, not currently being used in the company's operations; and (3) long‐term notes receivable.

· Long‐term liabilities (long‐term debt) Obligations that a company expects to pay after one year.

· Materiality Whether an item is large enough to likely influence the decision of an investor or creditor.

· Monetary unit assumption An assumption that requires that only those things that can be expressed in money are included in the accounting records.

· Operating cycle The average time required to purchase inventory, sell it on account, and then collect cash from customers—that is, go from cash to cash.

· Periodicity assumption An assumption that the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business.

· Profitability ratios Measures of the operating success of a company for a given period of time.

· Property, plant, and equipment Assets with relatively long useful lives that are currently used in operating the business.

· Public Company Accounting Oversight Board (PCAOB) The group charged with determining auditing standards and reviewing the performance of auditing firms.

· Ratio An expression of the mathematical relationship between one quantity and another.

· Ratio analysis A technique that expresses the relationship among selected items of financial statement data.

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

· Securities and Exchange Commission (SEC) The agency of the U.S. government that oversees U.S. financial markets and accounting standard‐setting bodies.

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

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

· Timely Information that is available to decision‐makers before it loses its capacity to influence decisions.

· Understandability Information presented in a clear and concise fashion so that users can interpret it and comprehend its meaning.

· Verifiable The quality of information that occurs when independent observers, using the same methods, obtain similar results.

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

PRACTICE MULTIPLE-CHOICE QUESTIONS

(LO 1)

1. In a classified balance sheet, assets are usually classified as:

(a) current assets; long‐term assets; property, plant, and equipment; and intangible assets.

(b) current assets; long‐term investments; property, plant, and equipment; and common stock.

(d) current assets; long‐term investments; property, plant, and equipment; and intangible assets.

(LO 1)

2. Current assets are listed:

(a) by order of expected conversion to cash.

(b) by importance.

(d) alphabetically.

(LO 1)

3. The correct order of presentation in a classified balance sheet for the following current assets is:

(a) accounts receivable, cash, prepaid insurance, inventory.

(b) cash, inventory, accounts receivable, prepaid insurance.

(d) inventory, cash, accounts receivable, prepaid insurance.

(LO 1)

4. A company has purchased a tract of land. It expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. The land should be reported as:

(a) property, plant, and equipment.

(b) land expense.

(d) an intangible asset.

(LO 1)

5. The balance in retained earnings is not affected by:

(a) net income.

(b) net loss.

(d) dividends.

(LO 2)

6. Which is an indicator of profitability?

(a) Current ratio.

(b) Earnings per share.

(d) Free cash flow.

(LO 2)

7. For 2017, Spanos Corporation reported net income $26,000, net sales $400,000, and weighted‐average shares outstanding 4,000. There were preferred dividends of $2,000. What was the 2017 earnings per share?

(a) $6.00.

(b) $6.50.

(d) $100.00.

(LO 2)

8. Which of these measures is an evaluation of a company's ability to pay current liabilities?

(a) Earnings per share.

(b) Current ratio.

(d) None of the above.

(LO 2)

9. The following ratios are available for Reilly Inc. and O'Hare Inc.

	Current Ratio	Debt to Assets Ratio	Earnings per Share
Reilly Inc.	2:1	75%	$3.50
O'Hare Inc.	1.5:1	40%	$2.75

Compared to O'Hare Inc., Reilly Inc. has:

(a) higher liquidity, higher solvency, and higher profitability.

(b) lower liquidity, higher solvency, and higher profitability.

(d) higher liquidity and lower solvency, but profitability cannot be compared based on information provided.

(LO 2)

10. Companies can use free cash flow to:

(a) pay additional dividends.

(b) acquire more property, and equipment.

(d) All of the above.

(LO 3)

11. 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.

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

(LO3)

12. What organization issues U.S. accounting standards?

(a) Financial Accounting Standards Board.

(b) International Accounting Standards Committee.

(d) None of the above.

(LO 3)

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

(a) Consistency.

(b) Predictive value.

(d) Comparability.

(LO 3)

14. Neutrality is an ingredient of:

	Faithful Representation	Relevance
(a)	Yes	Yes
(b)	No	No
(c)	Yes	No
(d)	No	Yes

(LO 3)

15. The characteristic of information that evaluates whether it is large enough to impact a decision.

(a) Comparability.

(b) Materiality.

(d) Consistency.

SOLUTIONS

1. (d) Assets are classified as current assets; long‐term investments; property, plant and equipment; and intangible assets. The other choices are incorrect because (a) long‐term assets includes long‐term investments; property, plant, and equipment; and intangible assets; (b) common stock refers to the equity of the firm and is not an asset; and (c) while tangible assets describes property, plant, and equipment, it is better to use the more common terminology of property, plant, and equipment.

2. (a) Current assets should be listed by order of expected conversion to cash (liquidity), not (b) by importance, (c) by longevity, or (d) alphabetically.

3. (c) The correct order of presentation for current assets is cash, accounts receivable, inventory, and then prepaid insurance. The other choices are therefore incorrect.

4. (c) Land or buildings that are currently not used in operations are considered to be long‐term investments. The other choices are incorrect because (a) this classification is for property, plant, and equipment used in operations; (b) land is never expensed; and (d) intangible assets have no physical existence and are used in the production of income.

5. (c) Issuance of common stock has no impact on retained earnings. The other choices are incorrect because (a) net income increases retained earnings, (b) net loss decreases retained earnings, and (d) dividends decrease retained earnings.

6. (b) Earnings per share is a measure of profitability. The other choices are incorrect because (a) the current ratio is a measure of liquidity, (c) the debt to assets ratio is a measure of solvency, and (d) free cash flow is a measure of solvency.

7. (a) Earnings per share = Net income ($26,000) less Preferred dividends ($2,000) divided by Weighted‐average shares outstanding (4,000) = $6.00/share, not (b) $6.50, (c) $99.50, or (d) $100.00.

8. (b) The current ratio measures liquidity. Higher current ratios indicate higher liquidity. The other choices are incorrect because (a) earnings per share is a measure of a firm's profitability, not its ability to pay its current liabilities; (c) one of these answers is incorrect; and (d) there is a correct answer.

9. (d) Reilly Inc. has higher liquidity as it has a higher current ratio, and lower solvency due to its higher debt to assets ratio. However, profitability cannot be compared across companies using earnings per share because of the wide variations in the number of shares of common stock of different companies. The other choices are therefore incorrect.

10. (d) Free cash flow can be used to pay dividends; acquire more property, plant, and equipment; and pay off debts. Although choices (a), (b), and (c) are correct, choice (d) is the better answer.

11. (a) All U.S. companies get guidance from a set of rules and practices that have authoritative support, referred to as generally accepted accounting principles (GAAP). Standard‐setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards. The other choices are incorrect because GAAP is (b) not established by the Internal Revenue Service, (c) not intended to provide guidance in resolving ethical dilemmas, or (d) created by people and can evolve over time, unlike laws of nature, such as those in physics and chemistry.

12. (a) The Financial Accounting Standards Board (FASB) is the organization that issues U.S. accounting standards, not the (b) International Accounting Standards Committee or (c) International Auditing Standards Committee. Choice (d) is wrong as there is a correct answer.

13. (c) Usefulness for decision‐making is the primary criterion by which accounting information can be judged. The other choices are incorrect because (a) consistency, (b) predictive value, and (d) comparability all help to make accounting information more useful but are not the primary criterion by which accounting information is judged.

14. (c) Neutrality is an ingredient of faithful representation but not relevance. The other choices are therefore incorrect.

15. (b) Materiality evaluates whether information is large enough to impact a decision, not (a) comparability, (c) cost, or (d) consistency.

PRACTICE EXERCISES

Prepare assets section of a classified balance sheet.

(LO 1)

1. Suppose the following information (in thousands of dollars) is available for H. J. Heinz Company—famous for ketchup and other fine food products—for the year ended April 30, 2017.

Prepaid insurance	$ 168,182	Buildings	$4,344,269
Land	56,007	Cash	617,687
Goodwill	4,411,521	Accounts receivable	1,161,481
Trademarks	723,243	Accumulated depreciation—buildings	2,295,563
Inventory	1,378,216

INSTRUCTIONS

Prepare the assets section of a classified balance sheet, listing the items in proper sequence and including a statement heading.

SOLUTION

H. J. HEINZ COMPANY Partial Balance Sheet April 30, 2017 (in thousands)
Assets
Current assets
Cash		$ 617,687
Accounts receivable		1,161,481
Inventory		1,378,216
Prepaid insurance		168,182
Total current assets			$ 3,325,566
Property, plant, and equipment
Land		56,007
Buildings	$4,344,269
Less: Accumulated depr.—buildings	2,295,563	2,048,706	2,104,713
Intangible assets
Goodwill		4,411,521
Trademarks		723,243	5,134,764
Total assets			$10,565,043

Compute and interpret various ratios.

(LO 2)

2. Suppose the following data were taken from the 2017 and 2016 financial statements of American Eagle Outfitters. (All dollars are in thousands.)

	2017	2016
Current assets	$1,020,834	$1,189,108
Total assets	1,867,680	1,979,558
Current liabilities	376,178	464,618
Total liabilities	527,216	562,246
Net income	400,019	387,359
Net cash provided by operating activities	464,270	749,268
Capital expenditures	250,407	225,939
Dividends paid on common stock	80,796	61,521
Weighted‐average shares outstanding	216,119	222,662

INSTRUCTIONS

Perform each of the following.

(a) Calculate the current ratio for each year.

(b) Calculate earnings per share for each year.

(d) Calculate the free cash flow for each year.

(e) Discuss American Eagle's solvency in 2017 versus 2016.

SOLUTION

	2017	2016
(a) current ratio	$1,020,834$376,178=2.71:1$1,020,834$376,178=2.71:1	$1,189,108$464,618=2.56:1$1,189,108$464,618=2.56:1
(b) Earnings per share	$400,019$216,119=$1.85$400,019$216,119=$1.85	$387,359$222,662=$1.74$387,359$222,662=$1.74
(c) Debt to assets ratio	$527,216$1,867,680=28.2%$527,216$1,867,680=28.2%	$562,246$1,979,558=28.4%$562,246$1,979,558=28.4%
(d) Free cash flow	$464,270−$250,407−80,796=$133,067$464,270−$250,407−80,796=$133,067	$749,268−$225,939−61,521=$461,808$749,268−$225,939−61,521=$461,808
(e) Using the debt to assets ratio and free cash flow as measures of solvency produces negative results for American Eagle Outfitters. Its debt to assets ratio decreased slightly from 28.4% for 2016 to 28.2% for 2017, indicating a very small increase in solvency for 2017. Its free cash flow decreased by 71%, indicating a significant decline in solvency.

PRACTICE PROBLEM

Prepare financial statements.

(LO 1)

Listed here are items taken from the income statement and balance sheet of Bargain Electronics, Inc. for the year ended December 31, 2017. Certain items have been combined for simplification. (Amounts are given in thousands.)

Notes payable (due in 3 years)	$ 50.5
Cash	141.1
Salaries and wages expense	2,933.6
Common stock	454.9
Accounts payable	922.2
Accounts receivable	723.3
Equipment, net	921.0
Cost of goods sold	9,501.4
Income taxes payable	7.2
Interest expense	1.5
Mortgage payable	451.5
Retained earnings	1,336.3
Inventory	1,636.5
Sales revenue	12,456.9
Debt investments (short‐term)	382.6
Income tax expense	30.5
Goodwill	202.7
Notes payable (due in 6 months)	784.6

INSTRUCTIONS

Prepare an income statement and a classified balance sheet using the items listed. Do not use any item more than once.

SOLUTION

BARGAIN ELECTRONICS, INC. Income Statement For the Year Ended December 31, 2017 (in thousands)
Revenues
Sales revenue		$12,456.9
Expenses
Cost of goods sold	$9,501.4
Salaries and wages expense	2,933.6
Interest expense	1.5
Income tax expense	30.5
Total expenses		12,467.0
Net loss		$ (10.1)

BARGAIN ELECTRONICS, INC. Balance Sheet December 31, 2017 (in thousands)
Assets
Current assets
Cash	$ 141.1
Debt investments	382.6
Accounts receivable	723.3
Inventory	1,636.5
Total current assets		$2,883.5
Equipment, net		921.0
Goodwill		202.7
Total assets		$4,007.2
Liabilities and Stockholders' Equity
Current liabilities
Notes payable	$ 784.6
Accounts payable	922.2
Income taxes payable	7.2
Total current liabilities		$1,714.0
Long-term liabilities
Mortgage payable	451.5
Notes payable	50.5	502.0
Total liabilities		2,216.0
Stockholders' equity
Common stock	454.9
Retained earnings	1,336.3
Total stockholders' equity		1,791.2
Total liabilities and stockholders' equity		$4,007.2

WileyPLUS

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

QUESTIONS

1. What is meant by the term operating cycle?

2. Define current assets. What basis is used for ordering individual items within the current assets section?

3. Distinguish between long‐term investments and property, plant, and equipment.

4. How do current liabilities differ from long‐term liabilities?

5. Identify the two parts of stockholders' equity in a corporation and indicate the purpose of each.

(a) Geena Lowe believes that the analysis of financial statements is directed at two characteristics of a company: liquidity and profitability. Is Geena correct? Explain.

(b) Are short‐term creditors, long‐term creditors, and stockholders primarily interested in the same characteristics of a company? Explain.

7. Name ratios useful in assessing (a) liquidity, (b) solvency, and (c) profitability.

8. Tom Dawes, the founder of Footwear Inc., needs to raise $500,000 to expand his company's operations. He has been told that raising the money through debt will increase the riskiness of his company much more than issuing stock. He doesn't understand why this is true. Explain it to him.

9. What do these classes of ratios measure?

(a) Liquidity ratios.

(b) Profitability ratios.

10. Holding all other factors constant, indicate whether each of the following signals generally good or bad news about a company.

(a) Increase in earnings per share.

(b) Increase in the current ratio.

(d) Decrease in free cash flow.

11. Which ratio or ratios from this chapter do you think should be of greatest interest to:

(a) a pension fund considering investing in a corporation's 20‐year bonds?

(b) a bank contemplating a short‐term loan?

12. (a) What are generally accepted accounting principles (GAAP)?

(b) What body provides authoritative support for GAAP?

13. (a) What is the primary objective of financial reporting?

(b) Identify the characteristics of useful accounting information.

14. Merle Hawkins, the president of Pathway Company, is pleased. Pathway substantially increased its net income in 2017 while keeping its unit inventory relatively the same. Jon Dietz, chief accountant, cautions Merle, however. Dietz says that since Pathway changed its method of inventory valuation, there is a consistency problem and it is difficult to determine whether Pathway is better off. Is Dietz correct? Why or why not?

15. What is the distinction between comparability and consistency?

16. Describe the constraint inherent in the presentation of accounting information.

17. Your roommate believes that accounting standards are uniform throughout the world. Is your roommate correct? Explain.

18. Wanda Roberts is president of Best Texts. She has no accounting background. Wanda cannot understand why fair value is not used as the basis for all accounting measurement and reporting. Discuss.

19. What is the economic entity assumption? Give an example of its violation.

20. What was Apple's largest current asset, largest current liability, and largest item under “Assets” at September 27, 2014?

BRIEF EXERCISES

Classify accounts on balance sheet.

(LO 1), K

BE2-1 The following are the major balance sheet classifications:

Current assets (CA)		Current liabilities (CL)
Long‐term investments (LTI)		Long‐term liabilities (LTL)
Property, plant, and equipment (PPE)		Common stock (CS)
Intangible assets (IA)		Retained earnings (RE)

Match each of the following accounts to its proper balance sheet classification.

1. ________ Accounts payable

2. ________ Accounts receivable

3. ________ Accumulated depreciation

4. ________ Buildings

5. ________ Cash

6. ________ Goodwill

7. ________ Income taxes payable

8. ________ Investment in long‐term bonds

9. ________ Land

10. ________ Inventory

11. ________ Patent

12. ________ Supplies

Prepare the current assets section of a balance sheet.

(LO 1), AP

BE2-2 A list of financial statement items for Chin Company includes the following: accounts receivable $14,000, prepaid insurance $2,600, cash $10,400, supplies $3,800, and debt investments (short‐term) $8,200. Prepare the current assets section of the balance sheet listing the items in the proper sequence.

Compute earnings per share.

(LO 2), AP

BE2-3 The following information (in millions of dollars) is available for Limited Brands for a recent year: sales revenue $9,043, net income $220, preferred dividend $0, and weighted‐average shares outstanding 333 million. Compute the earnings per share for Limited Brands.

Calculate liquidity ratios.

(LO 2), AP

BE2-4 These selected condensed data are taken from a recent balance sheet of Bob Evans Farms (in millions of dollars).

Cash		$ 29.3
Accounts receivable		20.5
Inventory		28.7
Other current assets		24.0
Total current assets		$102.5
Total current liabilities		$201.2

Compute working capital and the current ratio.

Calculate liquidity and solvency ratios.

(LO 2), AP

BE2-5 Ross Music Inc. reported the following selected information at March 31.

	2017
Total current assets	$262,787
Total assets	439,832
Total current liabilities	293,625
Total liabilities	376,002
Net cash provided by operating activities	62,300

Calculate (a) the current ratio, (b) the debt to assets ratio, and (c) free cash flow for March 31, 2017. The company paid dividends of $12,000 and spent $24,787 on capital expenditures.

Recognize generally accepted accounting principles.

(LO 3), K

BE2-6 Indicate whether each statement is true or false.

(a) GAAP is a set of rules and practices established by accounting standard‐setting bodies to serve as a general guide for financial reporting purposes.

(b) Substantial authoritative support for GAAP usually comes from two standards‐setting bodies: the FASB and the IRS.

Identify characteristics of useful information.

(LO 3), K

BE2-7 The accompanying chart shows the qualitative characteristics of useful accounting information. Fill in the blanks.

Identify characteristics of useful information.

(LO 3), K

BE2-8 Given the characteristics of useful accounting information, complete each of the following statements.

(a) For information to be ________, it should have predictive and confirmatory value.

(b) ________ means that information accurately depicts what really happened.

Identify characteristics of useful information.

(LO 3), K

BE2-9 Here are some qualitative characteristics of useful accounting information:

1. Predictive value

2. Neutral

3. Verifiable

4. Timely

Match each qualitative characteristic to one of the following statements.

__________ (a) Accounting information should help provide accurate expectations about future events.

__________ (b) Accounting information cannot be selected, prepared, or presented to favor one set of interested users over another.

__________ (c) The quality of information that occurs when independent observers, using the same methods, obtain similar results.

__________ (d) Accounting information must be available to decision‐makers before it loses its capacity to influence their decisions.

Define full disclosure principle.

(LO 3), K

BE2-10 The full disclosure principle dictates that:

(a) financial statements should disclose all assets at their cost.

(b) financial statements should disclose only those events that can be measured in dollars.

(c) financial statements should disclose all events and circumstances that would matter to users of financial statements.

(d) financial statements should not be relied on unless an auditor has expressed an unqualified opinion on them.

DO IT!

EXERCISES

Prepare assets section of balance sheet.

(LO 1), AP

DO IT! 2-1a Mylar Corporation has collected the following information related to its December 31, 2017, balance sheet.

Accounts receivable	$22,000	Equipment	$180,000
Accumulated depreciation—equipment	50,000	Inventory	58,000
Cash	13,000	Supplies	7,000

Prepare the assets section of Mylar Corporation's balance sheet.

Classify financial statement items by balance sheet classification.

(LO 1), AP

DO IT! 2-1b The following financial statement items were taken from the financial statements of Gomez Corp.

________ Trademarks

________ Notes payable (current)

________ Interest revenue

________ Income taxes payable

________ Debt investments (long‐term)

________ Unearned sales revenue

________ Inventory

________ Accumulated depreciation

________ Land

________ Common stock

________ Advertising expense

________ Mortgage payable (due in 3 years)

Match each of the financial statement items to its proper balance sheet classification. (See E2-1 , for a list of the balance sheet classifications.) If the item would not appear on a balance sheet, use “NA.”

Compute ratios and analyze.

(LO 2), AP

DO IT! 2-2 The following information is available for Nguoi Corporation.

	2017	2016
Current assets	$ 54,000	$ 36,000
Total assets	240,000	205,000
Current liabilities	22,000	30,000
Total liabilities	72,000	100,000
Net income	80,000	40,000
Net cash provided by operating activities	90,000	56,000
Preferred dividends	6,000	6,000
Common dividends	3,000	1,500
Expenditures on property, plant, and equipment	27,000	12,000
Shares outstanding at beginning of year	40,000	30,000
Shares outstanding at end of year	75,000	40,000

(a) Compute earnings per share for 2017 and 2016 for Nguoi, and comment on the change. Nguoi's primary competitor, Matisse Corporation, had earnings per share of $1 per share in 2017. Comment on the difference in the ratios of the two companies.

(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.

Identify financial accounting concepts and principles.

(LO 3), K

DO IT! 2-3 The following characteristics, assumptions, principles, and constraint guide the FASB when it creates accounting standards.

1. Relevance

2. Faithful representation

3. Comparability

4. Consistency

5. Monetary unit assumption

6. Economic entity assumption

7. Periodicity assumption

8. Going concern assumption

9. Historical cost principle

10. Full disclosure principle

11. Materiality

12. Cost constraint

Match each item above with a description below.

1. ________ Items not easily quantified in dollar terms are not reported in the financial statements.

2. ________ Accounting information must be complete, neutral, and free from error.

3. ________ Personal transactions are not mixed with the company's transactions.

4. ________ The cost to provide information should be weighed against the benefit that users will gain from having the information available.

5. ________ A company's use of the same accounting principles from year to year.

6. ________ Assets are recorded and reported at original purchase price.

7. ________ Accounting information should help users predict future events, and should confirm or correct prior expectations.

8. ________ The life of a business can be divided into artificial segments of time.

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

10. ________ The judgment concerning whether an item's size makes it likely to influence a decision‐maker.

11. ________ Assumes a business will remain in operation for the foreseeable future.

12. ________ Different companies use the same accounting principles.

EXERCISES

Classify accounts on balance sheet.

(LO 1), AP

E2-1 The following are the major balance sheet classifications.

1. Current assets (CA)

2. Long‐term investments (LTI)

3. Property, plant, and equipment (PPE)

4. Intangible assets (IA)

5. Current liabilities (CL)

6. Long‐term liabilities (LTL)

7. Stockholders' equity (SE)

Instructions

Classify each of the following financial statement items taken from Ming Corporation's balance sheet.

1. ________ Accounts payable

2. ________ Accounts receivable

3. ________ Accumulated depreciation—equipment

4. ________ Buildings

5. ________ Cash

6. ________ Interest payable

7. ________ Goodwill

8. ________ Income taxes payable

9. ________ Inventory

10. ________ Stock investments (to be sold in 7 months)

11. ________ Land (in use)

12. ________ Mortgage payable

13. ________ Supplies

14. ________ Equipment

15. ________ Prepaid rent

Classify financial statement items by balance sheet classification.

(LO 1), AP

E2-2 The major balance sheet classifications are listed in E2-1.

Instructions

Classify each of the following financial statement items based upon the major balance sheet classifications listed in E2-1.

1. ________ Prepaid advertising

2. ________ Equipment

3. ________ Trademarks

4. ________ Salaries and wages payable

5. ________ Income taxes payable

6. ________ Retained earnings

7. ________ Accounts receivable

8. ________ Land (held for future use)

9. ________ Patents

10. ________ Bonds payable

11. ________ Common stock

12. ________ Accumulated depreciation—equipment

13. ________ Unearned sales revenue

14. ________ Inventory

Classify items as current or noncurrent, and prepare assets section of balance sheet.

(LO 1), AP

E2-3 Suppose the following items were taken from the December 31, 2017, assets section of the Boeing Company balance sheet. (All dollars are in millions.)

Inventory	$16,933	Patents	$12,528
Notes receivable—due after December 31, 2018	5,466	Buildings	21,579
Notes receivable—due before December 31, 2018	368	Cash	9,215
Accumulated depreciation—buildings	12,795	Accounts receivable	5,785
		Debt investments (short‐term)	2,008

Instructions

Prepare the assets section of a classified balance sheet, listing the current assets in order of their liquidity.

Prepare assets section of a classified balance sheet.

(LO 1), AP

E2-4 Suppose the following information (in thousands of dollars) is available for H. J. Heinz Company—famous for ketchup and other fine food products—for the year ended April 30, 2017.

Prepaid insurance	$ 125,765	Buildings	$4,033,369
Land	76,193	Cash	373,145
Goodwill	3,982,954	Accounts receivable	1,171,797
Trademarks	757,907	Accumulated depreciation—buildings	2,131,260
Inventory	1,237,613

Instructions

Prepare the assets section of a classified balance sheet, listing the items in proper sequence and including a statement heading.

Prepare a classified balance sheet.

(LO 1), AP

E2-5 These items are taken from the financial statements of Longhorn Co. at December 31, 2017.

Buildings	$105,800
Accounts receivable	12,600
Prepaid insurance	3,200
Cash	11,840
Equipment	82,400
Land	61,200
Insurance expense	780
Depreciation expense	5,300
Interest expense	2,600
Common stock	60,000
Retained earnings (January 1, 2017)	40,000
Accumulated depreciation—buildings	45,600
Accounts payable	9,500
Notes payable	93,600
Accumulated depreciation—equipment	18,720
Interest payable	3,600
Service revenue	14,700

Instructions

Prepare a classified balance sheet. Assume that $13,600 of the note payable will be paid in 2018.

Prepare a classified balance sheet.

(LO 1), AP

E2-6 Suppose the following items were taken from the 2017 financial statements of Texas Instruments, Inc. (All dollars are in millions.)

Common stock	$2,826	Accumulated depreciation—equipment	$3,547
Prepaid rent	164	Accounts payable	1,459
Equipment	6,705	Patents	2,210
Stock investments (long‐term)	637	Notes payable (long‐term)	810
Debt investments (short‐term)	1,743	Retained earnings	6,896
Income taxes payable	128	Accounts receivable	1,823
Cash	1,182	Inventory	1,202

Instructions

Prepare a classified balance sheet in good form as of December 31, 2017.

Compute and interpret profitability ratio.

(LO 2), AP

E2-7 Suppose the following information is available for Callaway Golf Company for the years 2017 and 2016. (Dollars are in thousands, except share information.)

	2017	2016
Net sales	$1,117,204	$1,124,591
Net income (loss)	66,176	54,587
Total assets	855,338	838,078

Share information	2017	2016
Shares outstanding at year‐end	64,507,000	66,282,000
Preferred dividends	–0–	–0–

There were 73,139,000 shares outstanding at the end of 2015.

Instructions

(a) What was the company's earnings per share for each year?

(b) Based on your findings above, how did the company's profitability change from 2016 to 2017?

(c) Suppose the company had paid dividends on preferred stock and on common stock during the year. How would this affect your calculation in part (a)?

Prepare financial statements.

(LO 1, 2), AP

E2-8 These financial statement items are for Fairview Corporation at year‐end, July 31, 2017.

Salaries and wages payable	$ 2,080
Salaries and wages expense	57,500
Supplies expense	15,600
Equipment	18,500
Accounts payable	4,100
Service revenue	66,100
Rent revenue	8,500
Notes payable (due in 2020)	1,800
Common stock	16,000
Cash	29,200
Accounts receivable	9,780
Accumulated depreciation—equipment	6,000
Dividends	4,000
Depreciation expense	4,000
Retained earnings (beginning of the year)	34,000

Instructions

(a) Prepare an income statement and a retained earnings statement for the year. Fairview Corporation did not issue any new stock during the year.

(b) Prepare a classified balance sheet at July 31.

(d) Suppose that you are the president of Lunar Equipment. Your sales manager has approached you with a proposal to sell $20,000 of equipment to Fairview. He would like to provide a loan to Fairview in the form of a 10%, 5‐year note payable. Evaluate how this loan would change Fairview's current ratio and debt to assets ratio, and discuss whether you would make the sale.

Compute liquidity ratios and compare results.

(LO 2), AP

E2-9 Nordstrom, Inc. operates department stores in numerous states. Selected financial statement data (in millions of dollars) for a recent year follow.

	End of Year	Beginning of Year
Cash and cash equivalents	$ 72	$ 358
Receivables (net)	1,942	1,788
Merchandise inventory	900	956
Other current assets	303	259
Total current assets	$3,217	$3,361
Total current liabilities	$1,601	$1,635

Instructions

(a) Compute working capital and the current ratio at the beginning of the year and at the end of the year.

(b) Did Nordstrom's liquidity improve or worsen during the year?

Compute liquidity measures and discuss findings.

(LO 2), AP

E2-10 The chief financial officer (CFO) of Myeneke Corporation requested that the accounting department prepare a preliminary balance sheet on December 30, 2017, so that the CFO could get an idea of how the company stood. He knows that certain debt agreements with its creditors require the company to maintain a current ratio of at least 2:1. The preliminary balance sheet is as follows.

MYENEKE CORP. Balance Sheet December 30, 2017
Current assets			Current liabilities
Cash	$25,000		Accounts payable	$ 20,000
Accounts receivable	30,000		Salaries and wages payable	10,000	$ 30,000
Prepaid insurance	5,000	$ 60,000	Long-term liabilities
Equipment (net)		200,000	Notes payable		80,000
Total assets		$260,000	Total liabilities		110,000
			Stockholders' equity
			Common stock	100,000
			Retained earnings	50,000	150,000
			Total liabilities and stockholders' equity		$260,000

Instructions

(a) Calculate the current ratio and working capital based on the preliminary balance sheet.

(b) Based on the results in (a), the CFO requested that $20,000 of cash be used to pay off the balance of the Accounts Payable account on December 31, 2017. Calculate the new current ratio and working capital after the company takes these actions.

(d) Was it unethical for the CFO to take these steps?

Compute and interpret solvency ratios.

(LO 2), AP

E2-11 Suppose the following data were taken from the 2017 and 2016 financial statements of American Eagle Outfitters. (All numbers, including share data, are in thousands.)

	2017	2016
Current assets	$ 925,359	$1,020,834
Total assets	1,963,676	1,867,680
Current liabilities	401,763	376,178
Total liabilities	554,645	527,216
Net income	179,061	400,019
Net cash provided by operating activities	302,193	464,270
Capital expenditures	265,335	250,407
Dividends paid on common stock	82,394	80,796
Weighted‐average shares outstanding	205,169	216,119

Instructions

Perform each of the following.

(a) Calculate the current ratio for each year.

(b) Calculate earnings per share for each year.

(d) Calculate the free cash flow for each year.

(e) Discuss American Eagle's solvency in 2017 versus 2016.

(f) Discuss American Eagle's ability to finance its investment activities with net cash provided by operating activities, and how any deficiency would be met.

Identify accounting assumptions and principles.

(LO 3), K

E2-12 Presented below are the assumptions and principles discussed in this chapter.

1. Full disclosure principle

2. Going concern assumption

3. Monetary unit assumption

4. Periodicity assumption

5. Historical cost principle

6. Economic entity assumption

Instructions

Identify by number the accounting assumption or principle that is described below. Do not use a number more than once.

__________ (a) Is the rationale for why plant assets are not reported at liquidation value. (Note: Do not use the historical cost principle.)

__________ (b) Indicates that personal and business recordkeeping should be separately maintained.

__________ (c) Assumes that the dollar is the “measuring stick” used to report on financial performance.

__________ (d) Separates financial information into time periods for reporting purposes.

__________ (e) Measurement basis used when a reliable estimate of fair value is not available.

__________ (f) Dictates that companies should disclose all circumstances and events that make a difference to financial statement users.

Identify the assumption or principle that has been violated.

(LO 3), C

E2-13 Lopez Co. had three major business transactions during 2017.

(a) Reported at its fair value of $260,000 merchandise inventory with a cost of $208,000.

(b) The president of Lopez Co., Victor Lopez, purchased a truck for personal use and charged it to his expense account.

(c) Lopez Co. wanted to make its 2017 income look better, so it added 2 more weeks to its income statement reporting period (a 54‐week year). Previous years were 52 weeks.

Instructions

In each situation, identify the assumption or principle that has been violated, if any, and discuss what the company should have done.

EXERCISES: SET B AND CHALLENGE EXERCISES

Visit the book's companion website, at www.wiley.com/college/kimmel , and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

PROBLEMS: SET A

Prepare a classified balance sheet.

(LO 1), AP

P2-1A Suppose the following items are taken from the 2017 balance sheet of Yahoo! Inc. (All dollars are in millions.)

Goodwill	$3,927
Common stock	6,283
Equipment	1,737
Accounts payable	152
Patents	234
Stock investments (long‐term)	3,247
Accounts receivable	1,061
Prepaid rent	233
Debt investments (short‐term)	1,160
Retained earnings	6,108
Cash	2,292
Notes payable (long‐term)	734
Unearned sales revenue	413
Accumulated depreciation—equipment	201

Instructions

Prepare a classified balance sheet for Yahoo! Inc. as of December 31, 2017.

Tot. current assets	$4,746
Tot. assets	$13,690

Prepare financial statements.

(LO 1), AP

P2-2A These items are taken from the financial statements of Martin Corporation for 2017.

Retained earnings (beginning of year)	$31,000
Utilities expense	2,000
Equipment	66,000
Accounts payable	18,300
Cash	10,100
Salaries and wages payable	3,000
Common stock	12,000
Dividends	12,000
Service revenue	68,000
Prepaid insurance	3,500
Maintenance and repairs expense	1,800
Depreciation expense	3,600
Accounts receivable	11,700
Insurance expense	2,200
Salaries and wages expense	37,000
Accumulated depreciation—equipment	17,600

Instructions

Prepare an income statement, a retained earnings statement, and a classified balance sheet as of December 31, 2017.

Net income	$21,400
Tot. assets	$73,700

Prepare financial statements.

(LO 1), AP

P2-3A You are provided with the following information for Lazuris Enterprises, effective as of its April 30, 2017, year‐end.

Accounts payable	$ 834
Accounts receivable	810
Accumulated depreciation—equipment	670
Cash	1,270
Common stock	900
Cost of goods sold	1,060
Depreciation expense	335
Dividends	325
Equipment	2,420
Income tax expense	165
Income taxes payable	135
Insurance expense	210
Interest expense	400
Inventory	967
Land	3,100
Mortgage payable	3,500
Notes payable	61
Prepaid insurance	60
Retained earnings (beginning)	1,600
Salaries and wages expense	700
Salaries and wages payable	222
Sales revenue	5,100
Stock investments (short‐term)	1,200

Instructions

(a) Prepare an income statement and a retained earnings statement for Lazuris Enterprises for the year ended April 30, 2017.

(a) Net income

$2,230

(b) Prepare a classified balance sheet for Lazuris Enterprises as of April 30, 2017.

(b)	Tot. current assets	$4,307
	Tot. assets	$9,157

Compute ratios; comment on relative profitability, liquidity, and solvency.

(LO 2), AN

P2-4A Comparative financial statement data for Loeb Corporation and Bowsh Corporation, two competitors, appear below. All balance sheet data are as of December 31, 2017.

	Loeb Corporation	Bowsh Corporation
	2017	2017
Net sales	$1,800,000	$620,000
Cost of goods sold	1,175,000	340,000
Operating expenses	283,000	98,000
Interest expense	9,000	3,800
Income tax expense	85,000	36,000
Current assets	407,200	190,336
Plant assets (net)	532,000	139,728
Current liabilities	66,325	33,716
Long-term liabilities	108,500	40,684
Net cash provided by operating activities	138,000	36,000
Capital expenditures	90,000	20,000
Dividends paid on common stock	36,000	15,000
Weighted-average number of shares outstanding	80,000	50,000

Instructions

(a) Comment on the relative profitability of the companies by computing the net income and earnings per share for each company for 2017.

(b) Comment on the relative liquidity of the companies by computing working capital and the current ratio for each company for 2017.

(c) Comment on the relative solvency of the companies by computing the debt to assets ratio and the free cash flow for each company for 2017.

Compute and interpret liquidity, solvency, and profitability ratios.

(LO 2), AP

P2-5A The following are financial statements of Ohara Company.

OHARA COMPANY Income Statement For the Year Ended December 31, 2017
Net sales	$2,218,500
Cost of goods sold	1,012,400
Selling and administrative expenses	906,000
Interest expense	78,000
Income tax expense	69,000
Net income	$ 153,100

OHARA COMPANY Balance Sheet December 31, 2017
Assets
Current assets
Cash	$ 60,100
Debt investments	84,000
Accounts receivable (net)	169,800
Inventory	145,000
Total current assets	458,900
Plant assets (net)	575,300
Total assets	$1,034,200
Liabilities and Stockholders' Equity
Current liabilities
Accounts payable	$ 160,000
Income taxes payable	35,500
Total current liabilities	195,500
Bonds payable	200,000
Total liabilities	395,500
Stockholders' equity
Common stock	350,000
Retained earnings	288,700
Total stockholders' equity	638,700
Total liabilities and stockholders' equity	$1,034,200

Additional information: The net cash provided by operating activities for 2017 was $190,800. The cash used for capital expenditures was $92,000. The cash used for dividends was $31,000. The weighted‐average number of shares outstanding during the year was 50,000.

Instructions

(a) Compute the following values and ratios for 2017. (We provide the results from 2016 for comparative purposes.)

(i) Working capital. (2016: $160,500)

(ii) Current ratio. (2016: 1.65:1)

(iii) Free cash flow. (2016: $48,700)

(iv) Debt to assets ratio. (2016: 31%)

(v) Earnings per share. (2016: $3.15)

(b) Using your calculations from part (a), discuss changes from 2016 in liquidity, solvency, and profitability.

Compute and interpret liquidity, solvency, and profitability ratios.

(LO 2), AP

P2-6A Condensed balance sheet and income statement data for Danke Corporation are presented as follows.

DANKE CORPORATION Balance Sheets December 31
Assets	2017	2016
Cash	$ 28,000	$ 20,000
Receivables (net)	70,000	62,000
Other current assets	90,000	73,000
Long-term investments	62,000	60,000
Property, plant, and equipment (net)	510,000	470,000
Total assets	$760,000	$685,000
Liabilities and Stockholders' Equity
Current liabilities	$ 75,000	$ 70,000
Long-term liabilities	80,000	90,000
Common stock	330,000	300,000
Retained earnings	275,000	225,000
Total liabilities and stockholders' equity	$760,000	$685,000

DANKE CORPORATION Income Statements For the Years Ended December 31
	2017	2016
Sales revenue	$750,000	$680,000
Cost of goods sold	440,000	400,000
Operating expenses (including income taxes)	240,000	220,000
Net income	$ 70,000	$ 60,000

Additional information:

Net cash provided by operating activities	$82,000	$56,000
Cash used for capital expenditures	$45,000	$38,000
Dividends paid	$20,000	$15,000
Weighted-average number of shares outstanding	33,000	30,000

Instructions

Compute these values and ratios for 2016 and 2017.

(a) Earnings per share.

(b) Working capital.

(d) Debt to assets ratio.

(e) Free cash flow.

(f) Based on the ratios calculated, discuss briefly the improvement or lack thereof in financial position and operating results from 2016 to 2017 of Danke Corporation.

Compute ratios and compare liquidity, solvency, and profitability for two companies.

(LO 2), AP

P2-7A Selected financial data of two competitors, Target and Wal‐Mart, are presented here. (All dollars are in millions.) Suppose the data were taken from the 2017 financial statements of each company.

	Target (1/31/17)	Wal-Mart (1/31/17)
	Income Statement Data for Year
Net sales	$64,948	$401,244
Cost of goods sold	44,157	306,158
Selling and administrative expenses	16,389	76,651
Interest expense	894	2,103
Other income	28	4,213
Income taxes	1,322	7,145
Net income	$ 2,214	$ 13,400

	Target	Wal-Mart
	Balance Sheet Data (End of Year)
Current assets	$17,488	$ 48,949
Noncurrent assets	26,618	114,480
Total assets	$44,106	$163,429
Current liabilities	$ 10,512	$ 55,390
Long-term liabilities	19,882	42,754
Total stockholders' equity	13,712	65,285
Total liabilities and stockholders' equity	$44,106	$163,429
Net cash provided by operating activities	$4,430	$23,147
Cash paid for capital expenditures	$3,547	$11,499
Dividends declared and paid on common stock	$465	$3,746
Weighted-average shares outstanding (millions)	774	3,951

Instructions

For each company, compute these values and ratios.

(a) Working capital.

(b) Current ratio.

(d) Free cash flow.

(e) Earnings per share.

(f) Compare the liquidity and solvency of the two companies.

Comment on the objectives and qualitative characteristics of financial reporting.

(LO 3), E

P2-8A A friend of yours, Saira Ortiz, recently completed an undergraduate degree in science and has just started working with a biotechnology company. Saira tells you that the owners of the business are trying to secure new sources of financing which are needed in order for the company to proceed with development of a new healthcare product. Saira said that her boss told her that the company must put together a report to present to potential investors.

Saira thought that the company should include in this package the detailed scientific findings related to the Phase I clinical trials for this product. She said, “I know that the biotech industry sometimes has only a 10% success rate with new products, but if we report all the scientific findings, everyone will see what a sure success this is going to be! The president was talking about the importance of following some set of accounting principles. Why do we need to look at some accounting rules? What they need to realize is that we have scientific results that are quite encouraging, some of the most talented employees around, and the start of some really great customer relationships. We haven't made any sales yet, but we will. We just need the funds to get through all the clinical testing and get government approval for our product. Then these investors will be quite happy that they bought in to our company early!”

Instructions

(a) What is accounting information? Explain to Saira what is meant by generally accepted accounting principles.

(b) Comment on how Saira's suggestions for what should be reported to prospective investors conforms to the qualitative characteristics of accounting information. Do you think that the things that Saira wants to include in the information for investors will conform to financial reporting guidelines?

PROBLEMS: SET B AND SET C

Visit the book's companion website, at www.wiley.com/college/kimmel , and choose the Student Companion site to access Problems: Set B and Set C.

CONTINUING PROBLEM

Cookie Creations

(Note: This is a continuation of the Cookie Creations problem from Chapter 1 .)

CC2 After investigating the different forms of business organization, Natalie Koebel decides to operate her business as a corporation, Cookie Creations Inc. She then begins the process of getting her business running.

Go to the book's companion website, www.wiley.com/college/kimmel , to see the completion of this problem.

EXPAND YOUR | CRITICAL THINKING

FINANCIAL REPORTING PROBLEM: Apple Inc.

CT2-1 The financial statements of Apple Inc. are presented in Appendix A at the end of this textbook.

Instructions

Answer the following questions using the financial statements and the notes to the financial statements.

(a) What were Apple's total current assets at September 27, 2014, and September 28, 2013?

(b) Are the assets included in current assets listed in the proper order? Explain.

(d) What were Apple's current liabilities at September 27, 2014, and September 28, 2013?

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT2-2 The financial statements of Columbia Sportswear Company are presented in Appendix B . Financial statements of VF Corporation are presented in Appendix C . Assume Columbia's weighted‐average number of shares outstanding was 227,514,000, and VF's was 56,997,000.

Instructions

(a) For each company, calculate the following values for 2014.

(1) Working capital.

(2) Current ratio.

(3) Debt to assets ratio.

(4) Free cash flow.

(Hint: When calculating free cash flow, do not consider business acquisitions to be part of capital expenditures.)

(b) Based on your findings above, discuss the relative liquidity and solvency of the two companies.

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal‐Mart Stores, Inc.

CT2-3 Amazon.com, Inc.'s financial statements are presented in Appendix D . Financial statements of Wal‐Mart Stores, Inc. are presented in Appendix E .

Instructions

(a) For each company, calculate the following values for 2014.

(1) Working capital.

(2) Current ratio.

(3) Debt to assets ratio.

(4) Free cash flow.

(b) Based on your findings above, discuss the relative liquidity and solvency of the two companies.

INTERPRETING FINANCIAL STATEMENTS

CT2-4 Suppose the following information was reported by Gap, Inc.

	2017	2016	2015	2014	2013
Total assets (millions)	$7,065	$7,985	$7,564	$7,838	$8,544
Working capital	$1,831	$2,533	$1,847	$1,653	$2,757
Current ratio	1.87:1	2.19:1	1.86:1	1.68:1	2.21:1
Debt to assets ratio	.42:1	.39:1	.42:1	.45:1	.39:1
Earnings per share	$1.89	$1.59	$1.35	$1.05	$0.94

(a) Determine the overall percentage decrease in Gap's total assets from 2013 to 2017. What was the average decrease per year?

(b) Comment on the change in Gap's liquidity. Does working capital or the current ratio appear to provide a better indication of Gap's liquidity? What might explain the change in Gap's liquidity during this period?

(d) Comment on the change in Gap's profitability during this period. How might this affect your prediction about Gap's future profitability?

REAL‐WORLD FOCUS

E CT2-5 Purpose: Identify summary liquidity, solvency, and profitability information about companies, and compare this information across companies in the same industry.

Address: http://biz.yahoo.com/i

Steps

1. Type in a company name, or use the index to find a company name. Choose Profile. Choose Key Statistics. Perform instruction (a) below.

2. Go back to Profile. Click on the company's particular industry behind the heading “Industry.” Perform instructions (b), (c), and (d).

Instructions

Answer the following questions.

(a) What is the company's name? What was the company's current ratio and debt to equity ratio (a variation of the debt to assets ratio)?

(b) What is the company's industry?

(d) Based on these measures, which company is more liquid? Which company is more solvent?

E CT2-6 The Feature Story described the dramatic effect that investment bulletin boards are having on the investment world. This exercise will allow you to evaluate a bulletin board discussing a company of your choice.

Address: http://biz.yahoo.com/i

Steps

1. Type in a company name, or use the index to find a company name.

2. Choose Msgs or Message Board. (for messages).

3. Read the 10 most recent messages.

Instructions

Answer the following questions.

(a) State the nature of each of these messages (e.g., offering advice, criticizing company, predicting future results, ridiculing other people who have posted messages).

(b) For those messages that expressed an opinion about the company, was evidence provided to support the opinion?

(c) What effect do you think it would have on bulletin board discussions if the participants provided their actual names? Do you think this would be a good policy?

S CT2-7 The July 6, 2011, edition of the Wall Street Journal Online includes an article by Michael Rapoport entitled “U.S. Firms Clash Over Accounting Rules.” The article discusses why some U.S. companies favored adoption of International Financial Reporting Standards (IFRS) while other companies opposed it.

Instructions

Read the article and answer the following questions.

(a) The articles says that the switch to IFRS tends to be favored by “larger companies, big accounting firms, and rule makers.” What reasons are given for favoring the switch?

(b) What two reasons are given by many smaller companies that oppose the switch?

(d) Explain what is meant by “condorsement.”

DECISION‐MAKING ACROSS THE ORGANIZATION

E CT2-8 As a financial analyst in the planning department for Erin Industries, Inc., you must develop ratios from the comparative financial statements. This information is to be used to convince creditors that, despite a slight decline in sales, Erin Industries, Inc. is liquid, solvent, and profitable, and that it deserves their continued support. Lenders are particularly concerned about the company's ability to continue as a going concern.

Here are the data requested and the computations developed from the financial statements:

	2017	2016
Current ratio	3.1	2.1
Working capital	Up 22%	Down 7%
Free cash flow	Up 25%	Up 18%
Debt to assets ratio	0.60	0.70
Net income	Up 32%	Down 8%
Earnings per share	$2.40	$1.15

Instructions

Erin Industries, Inc. asks you to prepare brief comments stating how each of these items supports the argument that its financial health is improving. The company wishes to use these comments to support presentation of data to its creditors. With the class divided into groups, prepare the comments as requested, giving the implications and the limitations of each item regarding Erin's financial well‐being.

COMMUNICATION ACTIVITY

S CT2-9 B. P. Palmer is the chief executive officer of Future Products. Palmer is an expert engineer but a novice in accounting.

Instructions

Write a letter to B. P. Palmer that explains (a) the three main types of ratios; (b) examples of each, how they are calculated, and what they measure; and (c) the bases for comparison in analyzing Future Products' financial statements.

ETHICS CASE

E CT2-10 At one time, Boeing closed a giant deal to acquire another manufacturer, McDonnell Douglas. Boeing paid for the acquisition by issuing shares of its own stock to the stockholders of McDonnell Douglas. In order for the deal not to be revoked, the value of Boeing's stock could not decline below a certain level for a number of months after the deal.

During the first half of the year, Boeing suffered significant cost overruns because of inefficiencies in its production methods. Had these problems been disclosed in the quarterly financial statements during the first and second quarters of the year, the company's stock most likely would have plummeted, and the deal would have been revoked. Company managers spent considerable time debating when the bad news should be disclosed. One public relations manager suggested that the company's problems be revealed on the date of either Princess Diana's or Mother Teresa's funeral, in the hope that it would be lost among those big stories that day. Instead, the company waited until October 22 of that year to announce a $2.6 billion write‐off due to cost overruns. Within one week, the company's stock price had fallen 20%, but by this time the McDonnell Douglas deal could not be reversed.

Instructions

Answer the following questions.

(a) Who are the stakeholders in this situation?

(b) What are the ethical issues?

(d) Do you think it is ethical to try to “time” the release of a story so as to diminish its effect?

(e) What would you have done if you were the chief executive officer of Boeing?

(f) Boeing's top management maintains that it did not have an obligation to reveal its problems during the first half of the year. What implications does this have for investors and analysts who follow Boeing's stock?

ALL ABOUT YOU

E CT2-11 Every company needs to plan in order to move forward. Its top management must consider where it wants the company to be in three to five years. Like a company, you need to think about where you want to be three to five years from now, and you need to start taking steps now in order to get there.

Instructions

Provide responses to each of the following items.

(a) Where would you like to be working in three to five years? Describe your plan for getting there by identifying between five and 10 specific steps that you need to take in order to get there.

(b) In order to get the job you want, you will need a résumé. Your résumé is the equivalent of a company's annual report. It needs to provide relevant and reliable information about your past accomplishments so that employers can decide whether to “invest” in you. Do a search on the Internet to find a good résumé format. What are the basic elements of a résumé?

(c) A company's annual report provides information about a company's accomplishments. In order for investors to use the annual report, the information must be reliable; that is, users must have faith that the information is accurate and believable. How can you provide assurance that the information on your résumé is reliable?

(d) Prepare a résumé assuming that you have accomplished the five to 10 specific steps you identified in part (a). Also, provide evidence that would give assurance that the information is reliable.

FASB CODIFICATION ACTIVITY

C CT2-12 If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following.

Instructions

(a) Access the glossary (“Master Glossary”) at the FASB Codification website to answer the following.

(1) What is the definition of current assets?

(2) What is the definition of current liabilities?

(b) A company wants to offset its accounts payable against its cash account and show a cash amount net of accounts payable on its balance sheet. Identify the criteria (found in the FASB Codification) under which a company has the right of set off. Does the company have the right to offset accounts payable against the cash account?

CONSIDERING PEOPLE, PLANET, AND PROFIT

E CT2-13 Auditors provide a type of certification of corporate financial statements. Certification is used in many other aspects of business as well. For example, it plays a critical role in the sustainability movement. The February 7, 2012, issue of the New York Times contained an article by S. Amanda Caudill entitled “Better Lives in Better Coffee,” which discusses the role of certification in the coffee business.

Address: http://scientistatwork.blogs.nytimes.com/2012/02/07/better‐lives‐in‐better‐coffee/

Instructions

Read the article and answer the following questions.

(a) The article mentions three different certification types that coffee growers can obtain from three different certification bodies. Using financial reporting as an example, what potential problems might the existence of multiple certification types present to coffee purchasers?

(b) According to the author, which certification is most common among coffee growers? What are the possible reasons for this?

(c) What social and environmental benefits are coffee certifications trying to achieve? Are there also potential financial benefits to the parties involved?

LEARNING OBJECTIVE 4

Compare the classified balance sheet format under GAAP and IFRS.

The classified balance sheet, although generally required internationally, contains certain variations in format when reporting under IFRS.

KEY POINTS

Following are the key similarities and differences between GAAP and IFRS related to the financial statements.

Similarities

· IFRS generally requires a classified statement of financial position similar to the classified balance sheet under GAAP.

· IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities.

Differences

· IFRS 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 IFRS. 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

· Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last.

· IFRS has many differences in terminology from what are shown in your textbook. For example, in the sample statement of financial position illustrated on the next page, notice in the investment category that stock is called shares.

· Both GAAP and IFRS are increasing the use of fair value to report assets. However, at this point IFRS has adopted it more broadly. As examples, under IFRS companies can apply fair value to property, plant, and equipment, and in some cases intangible assets.

FRANKLIN CORPORATION Statement of Financial Position October 31, 2017
Assets
Intangible assets
Patents			$ 3,100
Property, plant, and equipment
Land		$10,000
Equipment	$24,000
Less: Accumulated depreciation	5,000	19,000	29,000
Long-term investments
Share investments		5,200
Investment in real estate		2,000	7,200
Current assets
Prepaid insurance		400
Supplies		2,100
Inventory		3,000
Notes receivable		1,000
Accounts receivable		7,000
Debt investments		2,000
Cash		6,600	22,100
Total assets			$61,400
Equity and Liabilities
Equity
Share capital			$20,050
Retained earnings			14,000
Non-current liabilities
Mortgage payable		$10,000
Notes payable		1,300	11,300
Current liabilities
Notes payable		11,000
Accounts payable		2,100
Salaries and wages payable		1,600
Unearned service revenue		900
Interest payable		450	16,050
Total equity and liabilities			$61,400

LOOKING TO THE FUTURE

The IASB and the FASB 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://www.fasb.org/project/‐financial_statement_presentation.shtml.

IFRS Practice

IFRS SELF‐TEST QUESTIONS

1. 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 IFRS, the land should be reported as:

(a) land expense.

(b) property, plant, and equipment.

(d) a long‐term investment.

2. Current assets under IFRS are listed generally:

(a) by importance.

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

(d) alphabetically.

3. Companies that use IFRS:

(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.

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

4. Companies that follow IFRS to prepare a statement of financial position generally use the following order of classification:

(a) current assets, current liabilities, non‐current assets, non‐current liabilities, equity.

(b) non‐current assets, non‐current liabilities, current assets, current liabilities, equity.

(d) equity, non‐current assets, current assets, non‐current liabilities, current liabilities.

IFRS EXERCISES

IFRS2-1 In what ways does the format of a statement of financial of position under IFRS often differ from a balance sheet presented under GAAP?

IFRS2-2 What term is commonly used under IFRS in reference to the balance sheet?

IFRS2-3 The statement of financial position for Sundell Company includes the following accounts (in British pounds): Accounts Receivable £12,500, Prepaid Insurance £3,600, Cash £15,400, Supplies £5,200, and Debt Investments (short‐term) £6,700. Prepare the current assets section of the statement of financial position, listing the accounts in proper sequence.

IFRS2-4 The following information is available for Lessila Bowling Alley at December 31, 2017.

Buildings	$128,800	Share Capital	$100,000
Accounts Receivable	14,520	Retained Earnings (beginning)	15,000
Prepaid Insurance	4,680	Accumulated Depreciation—Buildings	42,600
Cash	18,040	Accounts Payable	12,300
Equipment	62,400	Notes Payable	97,780
Land	64,000	Accumulated Depreciation—Equipment	18,720
Insurance Expense	780	Interest Payable	2,600
Depreciation Expense	7,360	Bowling Revenues	14,180
Interest Expense	2,600

Prepare a classified statement of financial position. Assume that $13,900 of the notes payable will be paid in 2018.

INTERNATIONAL COMPARATIVE ANALYSIS PROBLEM: Apple vs. Louis Vuitton

IFRS2-5 The financial statements of Louis Vuitton are presented in Appendix F . Instructions for accessing and using the company's complete annual report, including the notes to its financial statements, are also provided in Appendix F .

Instructions

Identify five differences in the format of the statement of financial position used by Louis Vuitton compared to a company, such as Apple, that follows GAAP. (Apple's financial statements are available in Appendix A .)

Answers to IFRS Self‐Test Questions

1. d 2. b 3. c 4. c