Chapter 2 – Financial Statements & the Annual Report

Objectives of Financial Reporting

• Financial reporting has one primary objective: to provide useful information to those who must
make financial decisions.
• The balance sheet tells what obligations will be due in the near future and what assets will be
available to satisfy them.
• The income statement tells the revenues and expenses for a period of time.
• The statement of cash flows tells where cash came from and how it was used during the period.
• The notes in financial statements provide essential details about the company’s accounting
policies and other key factors that affect its financial condition and performance.
• Users include both the management of a company (internal users) and others not involved in the
daily operations of the business (external users).
• Consolidated financial statements reflect the position and results of all operations that are
controlled by a single entity.
• As a minimum standard, the SEC requires that the annual report include balance sheets as of the
two most recent year-ends and income statements for each of the three most recent years.
• Three secondary objectives follow from the primary objective of financial reporting:
1. Reflect Prospective Cash Receipts to Investors and Creditors
2. Reflect Prospective Cash Flows to the Company
3. Reflect the Company’s Resources and Claims to Its Resources

Qualitative Characteristics that make Accounting Information

Useful
Understandability
• Understandability is the quality of accounting information that makes it comprehensible to those
willing to spend the necessary time.
• The understandability varies considerable depending on the user’s background.

Relevance
• Relevance is the capacity of information to make a difference in a decision.

Reliability
• Reliability is the quality that makes accounting information dependable in representing the events
that it purports to represent.
• Reliability has three basic characteristics:
1. Verifiability: information that is free from error.
2. Representational faithfulness: information that corresponds to an actual event.
3. Neutrality: information that is not slanted to portray a company’s position in a better or worse
light than the actual circumstances would dictate.

Comparability & Consistency

• Comparability: for accounting information, the quality that allows a user to analyze two or more
companies and look for similarities and differences.
• Disclosure of accounting policies allows the reader to make a subjective adjustment to the
statements of one or more of the companies and thus to compensate for the different
depreciation method being used.
• Consistency: for accounting information, the quality that allows a user to compare two or more
accounting periods for a single company.
• Whereas financial statements are comparable when they can be compared between one company
and another, statements are consistent when they can be compared within a single company from
one accounting period to the next.
• Occasionally, companies decide to change their accounting method. Changes in accounting
methods from one period to the next do not make comparisons impossible, only more difficult.

Materiality
• Materiality: the magnitude of an accounting information omission or misstatement that will affect
the judgment of someone relying on the information.
• Materiality deals with the size of an error in accounting information. Slight errors will not affect
any decisions, minor expenditures of this nature are considered immaterial and are accounted for
as an expense of the period.
• The threshold for determining materiality varies from one company to the next depending largely
on the company’s size.
• Many companies establish policies that any expenditure under a certain dollar amount should be
accounted for as an expense of the period.

Conservatism
• Conservatism: the practice of using the least optimistic estimate when two estimates of amounts
are about equally likely.
• In the earlier days, it was customary to deliberately understate assets on the balance sheet
because this resulted in an even larger margin of safety that the assets being provided as collateral
for a loan were sufficient.
• Nowadays, the practice of conservatism is reserved for those situations in which there is
uncertainty about how to account for a particular item or transaction.

The Classified Balance Sheet

• A classified balance sheet separates both assets and liabilities into current and noncurrent.
• Current assets will be realized in cash, sold, or consumed during the operating cycle or within one
year if the cycle is shorter than one year.
• Current liabilities will be satisfied within the next cycle or within one year if the cycle is shorter
than one year.
• Operating cycle: the period of time between the purchase of inventory and the collection of any
receivable from the sale of the inventory.

Current Assets
• Current asset: an asset that is expected to be realized in cash or sold or consumed during the
operating cycle or within one year if the cycle is shorter than one year.
• Examples of current assets: cash, marketable securities, accounts receivable, merchandise
inventory, prepaid insurance, store supplies, etc.
• If investments are made for the short term, they are classified as current and are typically called
short-term investments or marketable securities.
Noncurrent Assets
• Any asset not meeting the definition of a current asset is classified as long term or noncurrent.
• Three common categories of long-term assets are investments; property, plant, and equipment;
and intangibles.

1. Investments
• Securities not expected to be sold within the next year are classified as investments.
• In many cases, the investment is in the common stock of another company. Sometimes,
companies invest in another company to exercise some influence over it or to control its
operations.
• Other assets classified as investments are land held for future use and buildings and equipment
not currently used in operations.

2. Property, Plant & Equipment

• Land, buildings, equipment, machinery, furniture and fixtures, trucks, and tools are all examples
of assets held for use in the operation of a business rather than for resale.
• The distinction between inventory and equipment, for instance, depends on the company’s
intent in acquiring the asset.
• The relative size of property, plant, and equipment depends largely on a company’s business.
• Regardless of the relative size of property, plant, and equipment, all assets in this category are
subject to depreciation except land.

3. Intangibles
• Intangible assets lack physical substance, but are similar to property, plant, and equipment in
that they provide benefits to the firm over the long term.
• Trademarks, copyrights, franchise rights, patents, and goodwill are examples of intangible
assets.
• The cost principle governs the accounting for intangibles, just as it does for tangible assets.
• Depreciation is the name given to the process of writing off tangible assets; the same process
for intangible assets is called amortization.

Current Liabilities
• Current liability: an obligation that will be satisfied within the next operating cycle or within one
year if the cycle is shorter than one year.
• Examples of current liabilities: accounts payable, salaries & wages payable, income taxes payable,
interest payable, bank loan payable, etc.
• Most liabilities are satisfied by the payment of cash.

Long-Term Liabilities
• Any obligation that will not be paid or otherwise satisfied within the next year or the operating
cycle, whichever is longer, is classified as a long-term liability, or long-term debt.
• Notes payable and bonds payable, both promises to pay money in the future, are two common
forms of long-term debt.
Stockholder’s Equity
• Stockholders’ equity represents the owners’ claims on the assets of the business that arise from
two sources: contributed capital and earned capital.
• Contributed capital appears on the balance sheet in the form of capital stock, and earned capital
takes the form of retained earnings.
• Capital stock indicates the owners’ investment in the business.
• Retained earnings represents the accumulated earnings, or net income, of the business since its
inception less all dividends paid during that time.
• Common stock is the most basic form of ownership in a business and is an example of capital stock.
• Preferred stock is a form of capital stock that carries with it, certain preferences.
• All other claims against the company, such as those of creditors and preferred stockholders, take
priority over common stock.
• In the event of liquidation, preferred stockholders have priority over common stockholders in the
distribution of the entity’s assets.
• Capital stock may appear as two separate items on the balance sheet: Par Value and Paid-In Capital
in Excess of Par Value. The total of these two items tells us the amount that has been paid by the
owners for the stock.

Using a Classified Balance Sheet: Introduction to Ratios

Working Capital
• Investors, bankers, and other interested readers use the balance sheet to evaluate liquidity.
• Liquidity is a relative term and is the ability of a company to pay its debts as they come due.
• Working capital: current assets minus current liabilities, at a point in time:
Working Capital = Current Assets – Current Liabilities
• Working capital is limited in its informational value.
• A company must continually strive for a balance in managing its working capital.
 Too little working capital—or in the extreme, negative working capital—may signal the inability
to pay creditors on a timely basis.
 A large amount of working capital could indicate that the company is not investing enough of
its available funds in productive resources such as new machinery and equipment.

Current Ratio
• Current ratio: current assets divided by current liabilities.
Current Assets
Current Ratio =
Current Liabilities
• It allows us to compare the liquidity of companies of different sizes and of a single company over
time.
• The higher the current ratio, the more liquid the company.
• Some analysts use a rule of thumb of 2 to 1 for the current ratio as a sign of short-term financial
health. However, rules of thumb can be dangerous.
• In addition to the composition of the current assets, the frequency with which they are “turned
over” (converted to cash) is important.
• Ratios should be compared with those of prior years and with the same ratios for competitors.
The Income Statement
• The income statement summarizes the results of operations of an entity for a period of time.
• At a minimum, all companies prepare income statements at least once a year.
• Companies that must report to the SEC prepare financial statements, including an income
statement, every three months.
• Monthly income statements are usually prepared for internal use by management.
• The income statement reports the excess of revenue over expense— that is, the net income (or
in the event of an excess of expense over revenue, the net loss of the period).
• It is common to use the term profits or earnings as a synonym for net income.
• Revenue is the inflow of assets resulting from the sale of products and services.
• An expense is the outflow of assets resulting from the sale of goods and services for a period of
time. Wages and salaries, utilities, and taxes are examples of expenses.
• Certain special types of revenues, called gains, are sometimes reported on the income statement,
as are certain special types of expenses, called losses.

Format of the Income Statement

• Corporations use one of two formats to prepare the income statement: single-step or multiple-
step form.
• Both forms are generally accepted, although more companies use the multiple-step form.
• Single-step income statement: an income statement in which all expenses are added together and
subtracted from all revenues.
• The primary advantage of the single-step form is its simplicity.
• Multiple-step income statement: an income statement that shows classifications of revenues and
expenses as well as important subtotals.
• Cost of goods sold is the cost of the units of inventory sold during the year.
• In a multi-step income statement:
1. Sales and the costs of sales are compared: cost of goods sold is deducted from sales to arrive
at gross profit.
2. Expenses of the business are detailed.
3. Isolating expenses and revenues by type is useful in analyzing a business: Operating expenses
are further subdivided between selling expenses and general and administrative expenses.
4. Operating income is highlighted.
5. “Nonoperating” revenues and expenses are included after operating expenses.
• Depreciation on store furniture and fixtures is classified as a selling expense because the store is
where sales take place.
• The buildings are offices for the administrative staff; thus, depreciation on the buildings is
classified as a general and administrative expense.
• Interest revenue and interest expense, neither of which is an operating item, are included in other
revenues and expenses.
Using an Income Statement
• A company’s profit margin, computed by dividing net income by sales, is a good indicator of its
profitability (also known as return on sales).
• If the profit margin is high, this generally means that the company is generating revenue but that
it is also controlling its costs.
• Ratios should be compared with those of prior years and with the same ratios for competitors.
• Keep two key factors in mind when evaluating any financial statement ratio:
1. How does this year’s ratio differ from ratios of prior years?
2. How does the ratio compare with industry norms?

The Statement of Retained Earnings

• The statement of retained earnings reports the net income and any dividends declared during the
period. It is an important link between the income statement and the balance sheet.
• The purpose of a statement of stockholders’ equity is to explain the changes in the components
of owners’ equity during the period.
• Retained earnings and capital stock are the two primary components of stockholders’ equity.

The Statement of Cash Flows

• The statement of cash flows summarizes a company’s operating, investing, and financing activities
for the period.
• Each of these categories can result in a net inflow or a net outflow of cash.
• Operating activities concern the purchase and sale of a product.
• Investing activities involve the acquisition and sale of long-term or noncurrent assets such as long-
term investments; property, plant, and equipment; and intangible assets.
• Financing activities result from the issuance and repayment, or retirement, of long-term liabilities
and capital stock and the payment of dividends.

The Relationship between the Income Statement, Statement of

Retained Earnings and Balance Sheet