Chapter 2: A Further Look at Financial Statements

Current assets are listed: (a) by order of expected conversion to cash. (b) by importance. (c) by longevity. (d) alphabetically.

(a) by order of expected conversion to cash.

According to the FASB, useful information should possess two fundamental qualities

Relevance & faithful representation

Financial Accounting Standards Board (FASB)

The primary accounting standard-setting body in the United States.

Working Capital

current assets - current liabilities liquidity ratio

FY

fiscal year

Reporting only those things that can be measured in dollars.

monetary unit assumption

Intangible assets may also be reported under

other assets

most companies that follow IFRS present statement of financial position information in this order:

• Noncurrent assets • Current assets • Equity • Noncurrent liabilities • Current liabilities

At December 31, 2014, Shorts Company had retained earnings of $2,184,000. During 2014, the company issued stock for $98,000, and paid dividends of $34,000. Net income for 2014 was $402,000. How much was the retained earnings balance at the beginning of 2014? $2,552,000 $1,816,000 $2,454,000 $1,914,000

$1,816,000

Current liabilities are $10,000, long-term liabilities are $20,000, common stock is $50,000, and retained earnings totals $70,000. How much is total stockholders' equity? $140,000 $150,000 $70,000 $120,000

$120,000

Practice Question 14 For 2014, Stoneland Corporation reported net income, $24,000; net sales, $400,000; and average shares outstanding, 6,000. There were no preferred stock dividends. How much was the 2014 earnings per share? $0.06 $4.00 $16.67 $66.67

$4.00

For 2014, Ganos Corporation reported net income $26,000; net sales $400,000; and average shares outstanding 4,000. There were preferred dividends of $2,000. What was the 2014 earnings per share? (a) $6.00. (b) $6.50. (c) $99.50. (d) $100.00.

(a) $6.00. (26,000 - 4,000)

What organization issues U.S. accounting standards? (a) Financial Accounting Standards Board. (b) International Accounting Standards Committee. (c) International Auditing Standards Committee. (d) None of the above.

(a) Financial Accounting Standards Board.

Generally accepted accounting principles are: (a) a set of standards and rules that are recognized as a general guide for financial reporting. (b) usually established by the Internal Revenue Service. (c) the guidelines used to resolve ethical dilemmas. (d) fundamental truths that can be derived from the laws of nature.

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

Which of these measures is an evaluation of a company's ability to pay current liabilities? (a) Earnings per share. (b) Current ratio. (c) Both (a) and (b). (d) None of the above.

(b) Current ratio.

Which is an indicator of profitability? (a) Current ratio. (b) Earnings per share. (c) Debt to assets ratio. (d) Free cash flow.

(b) Earnings per share.

(LO 7) The characteristic of information that evaluates whether it is large enough to impact a decision. (a) Comparability. (b) Materiality. (c) Cost. (d) Consistency.

(b) Materiality.

Current assets under IFRS are listed generally: (a) by importance. (b) in the reverse order of their expected conversion to cash. (c) by longevity. (d) alphabetically.

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

(LO 7) Neutrality is an ingredient of: (a) Faithful representation and Relevance (b) Neither Faithful representation or relevance (c) Faithful Representation (d) Relevance

(c) Faithful Representation

What is the primary criterion by which accounting information can be judged? (a) Consistency. (b) Predictive value. (c) Usefulness for decision-making. (d) Comparability.

(c) Usefulness for decision-making.

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. (c) a long-term investment. (d) an intangible asset.

(c) a long-term investment

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

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

The balance in retained earnings is not affected by: (a) net income. (b) net loss. (c) issuance of common stock. (d) dividends.

(c) issuance of common stock.

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 statement of financial positions, rather than the underlying detailed line items. (c) may report noncurrent assets before current assets on the statement of financial position. (d) do not have any guidelines as to what should be reported on the statement of financial position.

(c) may report noncurrent assets before current assets on the statement of financial position.

Companies that follow IFRS to prepare a statement of financial position generally use the following order of classification: (a) current assets, current liabilities, noncurrent assets, noncurrent liabilities, equity. (b) noncurrent assets, noncurrent liabilities, current assets, current liabilities, equity. (c) noncurrent assets, current assets, equity, noncurrent liabilities, current liabilities. (d) equity, noncurrent assets, current assets, noncurrent liabilities, current liabilities.

(c) noncurrent assets, current assets, equity, noncurrent liabilities, current liabilities.

Companies can use free cash flow to: (a) pay additional dividends. (b) acquire property, plant, and equipment. (c) pay off debts. (d) All of the above.

(d) All of the above.

Which of the following statements is false? (a) The monetary unit assumption is used under IFRS. (b) Under IFRS, companies sometimes net liabilities against assets to report "net assets." (c) The FASB and IASB are working on a joint conceptual framework project. (d) Under IFRS, the statement of financial position is usually referred to as the statement of assets and equity.

(d) Under IFRS, the statement of financial position is usually referred to as the statement of assets and equity.

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. (c) an intangible asset. (d) a long-term investment.

(d) a long-term investment.

(LO 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. (c) current assets; long-term investments; tangible assets; and intangible assets. (d) current assets; long-term investments; property, plant, and equipment; and intangible assets.

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

(LO 2, 4) The following ratios are available for Bachus Inc. and Newton Inc. Current Ratio Debt to Assets Ratio Earnings per Share Bachus Inc. 2:1 75% $3.50 Newton Inc. 1.5:1 40% $2.75 Compared to Newton Inc., Bachus Inc. has: (a) higher liquidity, higher solvency, and higher profitability. (b) lower liquidity, higher solvency, and higher profitability. (c) higher liquidity, lower solvency, and higher profitability. (d) higher liquidity and lower solvency, but profitability cannot be compared based on information provided.

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

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. 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.

A company purchased a tract of land on which it expects to build a production plant on in approximately five years. During the five years before construction, the land will be idle. In what classification should the land be reported? An intangible asset A long-term investment Land expense Property, plant, and equipment

A long-term investment

Public Accounting Oversight Board (PCAOB)

A new oversight body for the accounting profession that was established by the Sarbanes-Oxley Act. Its job is to determine auditing standards and review the performance of auditing firms.

Fiscal Year (FY)

A twelve-month period that is used for bookkeeping, or accounting, purposes. Usually, the fiscal year does not coincide with the calendar year. For example, the federal government's fiscal year runs from October 1 through September 30.

For what purpose might a company use free cash flow? Pay additional dividends Acquire property, plant, and equipment Pay off debts All of the answer choices are correct

All of the answer choices are correct

International Accounting Standards Board (IASB)

An accounting standard-setting body that issues standards called International Financial Reporting Standards (IFRS) adopted by many countries outside of the United States.

Faithful Representation

complete, neutral, free from error 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.

current assets

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

Confirmatory Value

confirms or corrects prior expectations

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

consistency

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. 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.

current ratio

Current Assets/Current Liabilities, a liquidity ratio.

Depreciation

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).

Identify and compute ratios for analyzing a company's liquidity and solvency using a balance sheet.

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.

Current assets are economic resources that are expected to be converted to cash or used up by the business within one year or the normal operating cycle, whichever is shorter. True False

False

Use the statement of cash flows to evaluate solvency.

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.

What are the accounting rules that have substantial authoritative support and are recognized as a general guide for financial reporting purposes in the U. S.? Generally accepted auditing principles Generally accepted accounting standards Generally accepted accounting principles General accounting principles

Generally accepted accounting principles

Explain the meaning of generally accepted accounting principles.

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.

Classified Balance Sheet

Groups by current assets / fixed assets/ etc A balance sheet that 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.

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.

Record at cost or fair value

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.

Current Liabilities

Obligations that a company expects 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

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.

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.

fixed assets

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

plant assets

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

PCAOB

Public Company Accounting Oversight Board

Identify tools for analyzing financial statements and ratios for computing a company's profitability.

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.

enhancing qualities of useful information (7)

Relevance, faithful representation, Comparability, verifiability, timeliness, and understandability

SEC

Securities and Exchange Commission

Which of the following ratios measures the ability of the company to survive over a long period of time? Liquidity ratios Current ratios Profitability ratios Solvency ratios

Solvency ratios

operating cycle of company

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.

Explain the relationship between a retained earnings statement and a statement of stockholders' equity.

The retained earnings statement presents the factors that changed the retained earnings balance during the period. A statement of stockholders' equity presents the factors that changed stockholders' equity during the period, including those that changed retained earnings. Thus, a statement of stockholders' equity is more inclusive.

Discuss financial reporting concepts.

To be judged useful, information should have the primary characteristics of relevance and faithful representation. In addition, useful information is comparable, 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.

intangible assets

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

common stock is also known as

capital stock

Instead of a classified balance sheet, IFRS requires

classified statement of financial position except in very limited situations. IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities.

capital stock is also known as

common stock

Materiality

company-specific aspect of relevance. An item is material when its size makes it likely to influence the decision of an investor or creditor.

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

comparability

EPS formula

earnings available to common stockholders / average common shares outstanding = (net income - preferred dividends) / average common shares outstanding Earnings per Share Amount earned/gained/wealth grown per share outstanding we can evaluate its relative earnings performance from the perspective of a stockholder

Tracing accounting events to particular companies

economic entity assumption

Monetary Unit

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

ratio analysis

expresses the relationship among selected items of financial statement data

The desire to minimize errors and bias in financial statements.

faithful representation

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

full disclosure principle

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

going concern assumption

predictive value

helps provide accurate expectations about the future

Practice Question 23 The following ratios are available for Leer Inc. and Stable Inc. Leer Current ratio- 2:1 Debt to Assets- 75% Earning per Share $3.5 Stable Current ratio- 1.5:1 Debt to Assets- 40% Earning per Share $2.75 Compared to Stable Inc., Leer Inc. has higher liquidity and lower solvency, but profitability cannot be compared based on information provided. higher liquidity, higher solvency, but profitability cannot be compared based on information provided. higher liquidity, lower solvency, and higher profitability. lower liquidity, higher solvency, and higher profitablility.

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

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

historical cost principle

Principles in Financial Reporting (4)

historical cost, fair value, full disclosure, cost constraint

verifiable

if independent observers, using the same methods, obtain similar results

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.

Securities and Exchange Commission (SEC)

is a U.S. government agency that oversees securities transactions, activities of financial professionals and mutual fund trading to prevent fraud and intentional deception.

timely

it must be available to decision-makers before it loses its capacity to influence decisions

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

materiality

Consistency

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

Comparability

results when different companies use the same accounting principles. Another characteristic that enhances comparability is consistency.

Assumptions in Financial Reporting (4)

monetary unit, economic entity, periodicity, going concern

A company can change to a new method of accounting if management can justify that the new method results in terms of less likelihood of clerical errors. more meaningful financial information. a lower net income for tax purposes. a higher net income.

more meaningful financial information.

free cash flow

net cash provided by operating activities - capital expenditures - cash dividends paid measurement to provide additional insight regarding a company's cash-generating ability is free cash flow. Long-term creditors consider a high free cash flow amount an indication of solvency negative free cash flow could be cause for concern.

earnings available to common stockholders

net income - preferred dividends

The practice of preparing financial statements at regular intervals.

periodicity assumption

relevance

predictive value, confirmatory value, materiality, timely 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.

understandability

presented in a clear and concise fashion, so that reasonably informed users of that information can interpret it and comprehend its meaning.

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

relevance

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.

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.

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. 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.

debt to assets ratio

total liabilities/total assets (solvency) 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. 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.