Chapter 2 Notes: A Further Look at Financial Statements (Kimmel et al.)
Chapter 2: A Further Look at Financial Statements (Kimmel, Weygandt, Mitchell)
Purpose of this chapter: deepen understanding of the classified balance sheet and how it supports business decision making.
Key theme: assets = liabilities + stockholders’ equity, and assets/liabilities/equity are grouped by economic characteristics to improve clarity.
Classifications provide a snapshot of a company’s financial position at a point in time and aid users in evaluating liquidity, solvency, and equity position.
Classified Balance Sheet: Overview
Accounting equation:
Snapshot at a point in time; helps users understand financial position.
Grouping strategy: assets and liabilities are grouped by economic characteristics to reflect liquidity, long-term nature, and ownership.
Major asset classifications on the assets side:
Current assets
Long-term investments
Property, plant, and equipment (PP&E)
Intangible assets
Major sections on the liabilities and stockholders’ equity side:
Current liabilities
Long-term liabilities
Stockholders’ equity (common stock and retained earnings)
Example balance sheet structure (illustrative):
Assets: Current assets, Long-term investments, PP&E, Intangible assets
Liabilities and Stockholders’ Equity: Current liabilities, Long-term liabilities, Stockholders’ equity
Assets: Current Assets
Definition: assets a company expects to convert to cash or use up within one year or the operating cycle, whichever is longer.
Operating cycle: the average time to purchase inventory, sell on account, and collect cash; typically about one year.
Order of liquidity: listed in the order they are expected to turn into cash.
LO 1: Current Assets are the foundation for liquidity analysis.
Common Types of Current Assets:
Cash and cash equivalents
Short-term investments (e.g., short-term U.S. government securities)
Receivables (accounts receivable, notes receivable, interest receivable)
Inventories
Prepaid expenses (e.g., prepaid insurance and prepaid supplies)
Current assets example (partial Southwest Airlines balance sheet):
Cash and cash equivalents: $1,680
Short-term investments: $1,625
Accounts receivable: $546
Inventories: $337
Prepaid expenses and other current assets: $310
Total current assets: $4,498
Additional example ( Franklin Corporation, Oct 31, 2025):
Current assets total: $22,100
Examples included: Cash $6,600; Debt investments $2,000; Accounts receivable $7,000; Notes receivable $1,000; Inventory $3,000; Supplies $2,100; Prepaid insurance $400
Assets: Long-Term Investments
Definition: investments that can be realized in cash, but not expected to be converted within one year.
Often called investments, includes:
Investments in stocks and bonds of other corporations held >1 year
Long-term assets not currently used in operating activities (e.g., land or buildings held for investment)
Long-term notes receivable
LO 1
Example (Alphabet Inc., Balance Sheet partial):
Long-term investments: Non-marketable investments $5,183 (bond or stock characteristics indicated)
Assets: Property, Plant, and Equipment (PP&E)
Definition: assets with long useful lives (>1 year) used in operations; also called fixed assets or plant assets.
Typical components: Land, Buildings, Equipment, Delivery vehicles, Furniture
LO 1
PP&E is reported on the balance sheet at book value:
Depreciation: expense recognized on the income statement; systematic allocation of cost over asset’s useful life.
Accumulated Depreciation: contra-asset account; reduces PP&E total on the balance sheet.
Example (Equipment): cost $10,000; useful life 10 years; annual depreciation = $10,000 / 10 = $1,000.
After 3 years, Accumulated Depreciation = $3,000.
Presentation: PP&E net of accumulated depreciation is shown as property, plant, and equipment (with a deduction for accumulated depreciation).
Assets: Intangible Assets
Definition: assets with no physical substance; provide exclusive rights to use for a certain period.
Typical types: Goodwill, Patents, Copyrights, Trademarks/trade names
Sometimes reported under a broader category called “Other assets.”
LO 1
Example (The Walt Disney Company, partial balance sheet):
Intangible assets and goodwill total: $34,759 million
Specific items include: Character/franchise intangibles and copyrights $5,829; Other amortizable intangible assets $893; Accumulated amortization $(1,635); Net amortizable intangible assets $5,087; FCC licenses $624; Trademarks $1,218; Other indefinite-lived intangible assets $20; Goodwill $27,810.
Knowledge Check: Classifying Assets
Task: classify items into: Current assets, Intangible assets, Property, plant, and equipment, or Long-term investments.
Sample classifications (from slide):
Equipment → PPE
Long-term notes receivable → LTI (Long-term investments) or LT receivable (often grouped with LTI)
Accumulated depreciation → (contra-asset, shown within PPE as net PP&E)
Inventory → Current assets
Patents → Intangible assets
Cash → Current assets
Prepaid rent (or prepaid expenses) → Current assets
Note: Some items may be NA if they appear on income statement rather than balance sheet.
Assets: Summary Notes
Examples of asset classifications used in practice:
Current assets include cash, receivables, inventories, and prepaid expenses.
Long-term investments include investments in stocks/bonds held more than one year or non-operating investments.
PP&E include land, buildings, equipment, and delivery vehicles; presented at cost less accumulated depreciation.
Intangible assets include goodwill, patents, copyrights, and trademarks; amortization affects the income statement and accumulated amortization reduces the carrying amount of amortizable intangibles.
Classified Balance Sheet: Liabilities and Stockholders’ Equity
The liabilities and stockholders’ equity section mirrors the assets sections:
Current liabilities: obligations due within one year or the operating cycle, whichever is longer (e.g., accounts payable, notes payable, salaries/wages payable, interest payable, unearned revenue, income taxes payable, and current maturities of long-term obligations).
Long-term liabilities: obligations due after one year (often called long-term debt; includes long-term notes payable, bonds payable, mortgages payable, lease liabilities, pension liabilities).
Stockholders’ equity: two parts—Common stock and Retained earnings.
LO 1
Current liabilities example (Franklin Corporation, Oct 31, 2022):
Current liabilities total: $16,050
Includes: Notes payable $11,000; Accounts payable $2,100; Unearned sales revenue $900; Salaries and wages payable $1,600; Interest payable $450
Long-term liabilities example (Franklin): Mortgage payable $10,000; Notes payable $1,300; Total long-term liabilities $11,300; Total liabilities $27,350
Stockholders’ equity example (Franklin): Common stock $14,000; Retained earnings $20,050; Total stockholders’ equity $34,050
Total liabilities and stockholders’ equity equals total assets $61,400
Current Liabilities: Details and Interpretation
Definitions and examples of current liabilities are given to show near-term obligations.
Current maturities of long-term obligations: example of recognizing portion of long-term debt due within the next year.
LO 1
Long-Term (LT) Liabilities
Definition: obligations due after one year; commonly referred to as long-term debt.
Often reported as a single amount with details in notes to financial statements.
Includes: long-term notes payable, bonds payable, mortgages payable, lease liabilities, pension liabilities.
LO 1
Example: Nike, Inc. balance sheet (partial) shows long-term liabilities totaling $7,381 million (bonds payable $5,474; deferred income taxes and other $1,907).
Stockholders’ Equity
Two components:
Common stock: investments of assets into the business by the stockholders (ownership issued by the company).
Retained earnings: income earned and retained in the business.
LO 1
Knowledge Check: Classifying Balance Sheet Items
Classify accounts as CA, CL, LTI, LTL, PPE, SE, IA (or NA).
Sample answers (from slide):
Salaries and wages payable → CL
Common stock → SE
Unearned service revenue → CL
Retained earnings → SE
Mortgage payable (due in 3 years) → LTL
Accumulated depreciation—vehicles → PPE (net PPE when presented)
Practice: Prepare Classified Balance Sheet
Scenario: assume $13,600 of Notes Payable will be paid in the current year.
Steps (as outlined):
Step 1: Prepare Income Statement: Revenues − Expenses = Net Income
Step 2: Prepare Retained Earnings Statement: Beg RE + NI − Dividends = End RE
Additional note: Purpose is to distinguish current from long-term items and to prepare for decision-useful financial statements.
Liquidity Ratios: Current Ratio
Definition: measures the short-term ability to pay maturing obligations and meet unexpected cash needs.
Formula:
Interpretation: a ratio of 2.0 means $2 of current assets per $1 of current liabilities; higher is generally better for liquidity, but too high may imply inefficiency.
LO 3
Real-world caveat (Investor Insight): The current ratio can change when both numerator and denominator change by the same amount, potentially lowering or raising the ratio unexpectedly.
Example (simplified):
Start: current assets = $2,000,000; current liabilities = $1,000,000; current ratio = 2:1
If inventory purchase on account for $1,000,000: current assets = $3,000,000; current liabilities = $2,000,000; current ratio = 1.5:1
If instead $500,000 of current liabilities are paid: current assets = $1,500,000; current liabilities = $500,000; current ratio = 3:1
LO 3
Balance Sheets of Chicago Cereal (Illustrative Case)
2025 vs 2024 data (in thousands):
2025: Current assets $2,717; Total current assets; Current liabilities $4,044; Long-term liabilities $4,827; Stockholders’ equity $2,526; Total assets $11,397
2024: Current assets $2,427; Current liabilities $4,020; Long-term liabilities $4,625; Stockholders’ equity $2,069; Total assets $10,714
Current ratio (2025): (about 67 cents of current assets per $1 of current liabilities)
LO 3
Solvency (Leverage) Ratios
Purpose: assess long-term financial risk and the extent of debt financing.
Key ratios:
Debt to assets ratio:
Equity to assets ratio:
Debt to equity ratio:
LO 3
Interpreting the Debt to Assets Ratio
Measures the proportion of assets financed by debt; higher means more financial leverage and risk.
Lower is generally better; higher leverage implies greater risk of not meeting maturing obligations.
Example interpretation: If the ratio is 0.60, then 60% of assets are financed by debt.
LO 3
Formulas recap (for reference):
Debt to Assets (Chicago Cereal, 2025) and Related Ratios
2025 values (illustrative from slides):
Current liabilities: $4,044
Long-term liabilities: $4,827
Total assets: $11,397
Total equity: $2,526
Computed 2025 ratios:
Debt to assets:
Equity to assets:
Debt to equity:
Interpretation: Chicago Cereal’s 2025 debt-to-assets ratio of about 0.78 implies creditors financed roughly 78% of assets; equity-to-assets about 22%; debt-to-equity about 3.51, indicating higher leverage relative to equity.
LO 3
Equity to Assets Ratio
Definition and interpretation: Opposite of the debt ratio; measures proportion of assets financed by equity.
Higher equity ratio means lower leverage risk.
Chicago Cereal 2025 equity-to-assets ratio: about 0.22 (22%).
LO 3
Interpreting the Debt-to-Equity Ratio
Compares total debt to total shareholders’ equity.
A ratio of 1.5 means $1.50 of debt for every $1 of equity.
Lenders prefer lower ratios; high ratios imply credit risk and potential higher interest rates or loan denial.
Industry norms vary by sector (capital-intensive industries tend to have higher debt-to-equity).
LO 3
Debt to Equity (Chicago Cereal, 2025)
2025 ratio: ≈ 3.51 (indicating more debt per dollar of equity than the industry or some peers at that time).
LO 3
Learning Objective 3: Financial Reporting Concepts
LO 3
The Standard-Setting Environment
GAAP: Generally Accepted Accounting Principles – rules and practices with substantial authoritative support.
GAAP governs what information to disclose, how to present it, and how to measure assets, liabilities, revenues, and expenses.
LO 3
United States Standard-Setting Bodies
SEC: Oversees U.S. financial markets and accounting standard-setting bodies.
FASB: Primary accounting standard-setting body in the U.S.
LO 3
Qualities of Useful Information: Conceptual Framework
Purpose: basis for future accounting standards; used by FASB.
Primary objective: provide financial information useful to investors and creditors for decisions about providing capital.
Primary qualities:
Relevance
Faithful representation
LO 3
Relevance
Characteristics that make a difference in a decision:
Predictive value: helps forecast future outcomes
Confirmatory value: confirms or corrects prior expectations
Materiality: company-specific aspect; omitting or misstating information could influence user decisions
LO 3
Faithful Representation
Information should be:
Complete
Neutral
Free from material error
LO 3
Comparability and Consistency
Comparability: results when different companies use the same accounting principles.
Consistency: same accounting principles and methods used year to year by the same company.
LO 3
Accounting Across the Organization: Time Periods and Year-Ends
Accounting period concepts: fiscal year vs calendar year; year-ends do not have to be December 31.
Reasons for choosing different year-ends: align with low activity periods to reduce cost/effort, ease inventory counting, etc.
Examples of different year-ends: Delta Air Lines (June 30), The Walt Disney Company (Sept 30), Dunkin’ Donuts (Oct 31); Best Buy notes year-end near end of January.
LO 3
Measurement Principles
GAAP generally uses two measurement principles:
Historical cost principle
Fair value principle
Selection depends on trade-offs between relevance and faithful representation.
LO 3
Historical Cost Principle
Assets are recorded at the cost to acquire at the time of purchase.
Cost generally remains in the records; most assets follow historical cost due to representational faithfulness concerns with market values.
LO 3
Fair Value Principle
Assets and liabilities should be reported at fair value: the price to receive to sell an asset or to settle a liability.
Used only when assets are actively traded.
Two guiding qualities when choosing between cost and fair value: relevance and faithful representation.
LO 3
Extra Practice and Review: Balance Sheet Classifications
An exercise matching items to balance sheet classifications (CA, CL, LTI, LTL, PPE, SE, IA, NA).
Sample matches (from slide 51):
Prepaid expense → CA
Extra Practice: Balance Sheet Classifications (list):
Accounts payable → CL
Current assets (CA) → Cash, Accounts receivable, Inventory, Prepaid expenses
Long-term investments (LTI) → Investment in long-term bonds, Land held for investment
Property, plant, & equipment (PPE) → Building, Equipment, Land
Intangible assets (IA) → Patent, Goodwill, Copyrights, Trademarks
Accumulated depreciation → (contra-asset; net PPE on balance sheet)
Mortgage payable → LTL
Debt investments (short-term) → CA
Retained earnings → SE
Service revenue → NA (income statement)
Another sample exercise (Company-wide items listed in slide 52) demonstrates typical classifications.
Review Questions (Quick Checks)
53: Cash and other resources expected to be realized in cash or sold/consumed within one year or operating cycle are called: a) Current assets. (Answer: a)
54: Patents and copyrights are: b) Intangible assets. (Answer: b)
55: Which is not a long-term liability? b) Current maturities of long-term debt. (Answer: b)
56: The balance in retained earnings is not affected by: c) Issuance of common stock. (Answer: c)
57: Generally accepted accounting principles are: a) a set of standards and rules that are recognized as a general guide for financial reporting. (Answer: a)
Real-World Takeaways
The classification balance sheet helps users assess liquidity (short-term solvency) and long-term solvency.
Ratios such as current ratio and solvency ratios provide quick gauges of financial health but should be interpreted in context (industry norms, capitalization structure, and year-to-year trends).
Measurement choices (historical cost vs fair value) reflect trade-offs between relevance and faithful representation, with GAAP and FASB guiding practice.
Year-end timing can influence reported numbers and the workload of financial reporting; management may select year-ends to align with business cycles.
Quick reference formulas from the notes
Assets = Liabilities + Stockholders’ Equity
Current ratio:
Book value:
Depreciation per year (example):
Debt to assets ratio:
Equity to assets ratio:
Debt to equity ratio: