Financial Accounting Flashcards

Chapter 2: A Further Look at Financial Statements

Learning Objectives

• LO 1: Identify the sections of a classified balance sheet.
• LO 2: Use ratios to evaluate a company’s profitability, liquidity, and solvency.
• LO 3: Discuss financial reporting concepts.

The Classified Balance Sheet

• Presents a snapshot of a company's financial position at a specific point in time.
• Groups similar assets and similar liabilities together for better understanding.

Standard Classifications

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

Current Assets

• Assets that a company expects to convert to cash or use up within one year or the operating cycle, whichever is longer.
• The operating cycle is the average time to purchase inventory, sell goods, and collect cash from customers.
• Common types:
  • Cash
  • Short-term investments
  • Receivables
  • Inventories
  • Prepaid expenses
• Listed in order of liquidity (how quickly they can be converted to cash).
  Cash and cash equivalents: Most liquid assets, including money market holdings.
  Short-term investments: Very liquid assets (stocks, bonds, treasury bills) that mature in less than one year.
• Receivables:
  • Accounts receivable: Outstanding IOUs from customers for goods or services; expected to be collected within one year.
  • Notes receivable: Balance due on a promissory note (legally binding IOU); can be short-term (current) or long-term; refers to the principal component, with a separate interest component.
• Inventories: Goods held for sale; expected to be sold within one year.
• Supplies: Assets used in day-to-day operations; expected to be used up within one year.
• Prepaid Expenses: Payments made in advance for items like rent and insurance; represent future benefits to the company.

Long-Term Investments

• Investments in stocks and bonds of other corporations held for more than one year.
• Investments in long-term assets (land, buildings) not currently used in operating activities.
• Long-term notes receivable.

Property, Plant, and Equipment (PP&E)

• Long useful lives.
• Currently used in operations.
• Includes land, buildings, equipment, delivery vehicles, and furniture.
• Depreciation: Allocating the cost of assets over their useful lives.
• Depreciation expense: The amount of allocation for one accounting period.
• Accumulated depreciation: The total amount of depreciation expensed thus far in the asset’s life (contra-asset account).

Intangible Assets

• Assets that do NOT have physical substance.
• Includes goodwill, patents, copyrights, trademarks, and trade names.

Current Liabilities

• Obligations the company is to pay within the next year or operating cycle (whichever is longer).
• Common examples: accounts payable, salaries and wages payable, notes payable, interest payable, income taxes payable, and unearned revenue.
• Also includes current maturities of long-term obligations (payments due within the next year).
  Accounts Payable: Arising from operating activities such as purchasing goods on credit from suppliers.
  Notes Payable: Arising from financing activities and can be current or long-term.
• Unearned Revenue: A debt owed to a customer who has prepaid for goods or services because the company has not earned the revenue yet. Examples: magazine subscriptions, season tickets, airline tickets.
  Revenue is recognized when goods are delivered or services are performed.

Long-Term Liabilities

• Obligations a company expects to pay after one year.
• Include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities.

Stockholders’ Equity

• Common Stock: Investments of assets into the business by the stockholders.
• Retained Earnings: Income retained for use in the business.

Limitations of the Balance Sheet

• Assets are recorded at historical costs (rather than fair/market value) in most cases.
• Some current assets are valued on an estimated basis.
• Omissions of assets that cannot be expressed in monetary terms.

Using the Financial Statements

Ratio Analysis

• Expresses the relationship among selected items of financial statement data.
• A ratio expresses the mathematical relationship between one quantity and another.
• A single ratio by itself is not very meaningful. Requires:
  • Intracompany comparisons (two years for the same company)
  • Industry-average comparisons (average ratios for particular industries)
  • Intercompany comparisons (comparisons with a competitor in the same industry)

Financial Ratio Classifications

• Profitability Ratios: Measure the income or operating success of a company for a given period of time.
• Liquidity Ratios: Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
• Solvency Ratios: Measure the ability of the company to survive over a long period of time.

Using the Income Statement

• Reveals how successful a company is at generating a profit from selling products or providing services.
• Reports the annual amount earned as revenue during the period and the costs incurred as expenses during the period.

Earnings per Share (EPS)

• Key profitability ratio.
• Measures the net income earned on each share of common stock.
• Indicates the earnings available to common stockholders, omitting dividends paid to preferred stockholders.
• Used to compare earnings per share of a single company over time.

Earnings per Share Formula:
\text{Earnings per Share} = \frac{\text{Net Income} - \text{Preferred Stock Dividends}}{\text{Average Common Shares Outstanding}}

Using a Classified Balance Sheet

• Working Capital: The difference between current assets and current liabilities.

Working Capital Formula:
\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}

• Current Ratio: Measures short-term debt-paying ability.

Current Ratio Formula:
\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

• Solvency: The ability to pay interest as it comes due and to repay the balance of a debt due at its maturity.
• Debt to Assets Ratio: Measures the percentage of total financing provided by creditors.
  • The higher the debt to assets ratio, the lower is a company’s solvency.

Debt to Assets Ratio Formula:
\text{Debt to Assets Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}

Using the Statement of Cash Flows

• Free Cash Flow: Describes the net cash provided by operating activities after adjusting for capital expenditures and dividends paid.

Free Cash Flow Formula:
\text{Free Cash Flow} = \text{Net Cash Provided by Operating Activities} - \text{Capital Expenditures} - \text{Dividends Paid}

Financial Reporting Concepts

The Standard-Setting Environment

• Generally Accepted Accounting Principles (GAAP): A set of rules and practices, having substantial authoritative support, that the accounting profession recognizes as a general guide for financial reporting purposes in the USA.
• Standard-setting bodies:
  • Securities and Exchange Commission (SEC)
  • Financial Accounting Standards Board (FASB)
  • International Accounting Standards Board (IASB)
  • Public Company Accounting Oversight Board (PCAOB)

Standard-Setting Bodies

• Securities and Exchange Commission (SEC): Oversees U.S. financial markets and accounting standard-setting bodies.
• Financial Accounting Standards Board (FASB): Primary accounting standard-setting body in the U.S.
• International Accounting Standards Board (IASB): Creates international accounting standards (called IFRS); used by over 115 countries.
• Public Company Accounting Oversight Board (PCAOB): Determines U.S. auditing standards and reviews the performance of auditing firms.

Qualities of Useful Information

• Fundamental Qualities:
  • Relevance
  • Faithful representation
• Faithful Representation: Information accurately depicts what really happened; must be complete, neutral, and free from error.
• Relevance: Makes a difference in a business decision; provides information that has predictive and confirmatory value.
  • Materiality: An item is material when its size makes it likely to influence the decision of an investor or creditor.

Enhancing Qualities of Useful Information

• Comparability: Results when different companies use the same accounting principles.
• Verifiability: Independent observers, using the same methods, obtain similar results.
• Understandability: Information is presented in a clear and concise fashion.
• Consistency: A company uses the same accounting principles and methods from year to year.
• Timeliness: Information is available to decision-makers in time to be useful.

Assumptions in Financial Reporting

• Monetary Unit Assumption: Requires that only those things that can be expressed in money are included in the accounting records.
• Economic Entity Assumption: States that every economic entity can be separately identified and accounted for.
• Periodicity Assumption: States that the life of a business can be divided into artificial time periods.
• Going Concern Assumption: States that the business will remain in operation for the foreseeable future.

Principles

• Measurement:
  • Historical Cost: Dictates companies record assets at cost (also called the cost principle).
  • Fair Value: Indicates that assets and liabilities should be reported at fair value.
• Full Disclosure: Requires disclosure of all circumstances and events that would make a difference to financial statement users.

Revenue and Expense Recognition

• Revenue Recognition: Revenue is recognized when it is earned (work is done or product is delivered) and realized (assets are received and are readily convertible into cash).
• Expense Recognition (Matching): Expenses should be recognized in the same period as the revenues to which they relate.

Cost Constraint

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

A Look at IFRS

• 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 the statement of financial position is often presented differently under IFRS.
    • Non-current assets
    • Current assets
    • Equity
    • Non-current liabilities
    • Current liabilities
  • Under IFRS, current assets are usually listed in the reverse order of liquidity.
  • IFRS has many differences in terminology.
  • Both GAAP and IFRS are increasing the use of fair value to report assets. However, at this point, IFRS has adopted it more broadly.