Chapter 2: A further look at financial statements

Current Assets

Assets that are expected to be converted to cash or used in the business within a short period of time, usually one year. Examples of current assets include: cash, short-term investments, receivables, inventories and prepaid expenses. On the balance sheet, current assets are listed in the order in which the company expects to convert them into cash (order of liquidity).

Long-Term Investments Assets that can be

Assets that can be converted into cash, but whose conversion is not expected within one year. Assets not intended for use within the business. Examples are investments of stocks and bonds of other corporations.

Going concern assumption

Assumes business will be in existence for the foreseeable future. Allows use of capitalizing cost when recording assets.

SOLVENCY

The ability of the enterprise to survive over a long period of time.

Liquidity

The ability to pay short-term obligations as they come due.

classified balance sheet

Current Assets Long-term Investments Property, Plant, and Equipment Intangible Assets Current Liabilities Long-term Liabilities Stockholders' Equity

RELEVANCE

if information has the ability to make a difference in a decision scenario, it is relevant. Provides a basis for forecasts Confirms or corrects prior expectations Is timely

Profitability ratios

measure the income or operating success of an enterprise for a given period of time.

Earnings per share

measures the net income earned on each share of common stock and is computed by dividing net income available to common stockholders by the average number of common shares outstanding during the year.

Full disclosure principle

requires all circumstances and events that would make a difference to financial statement users to be disclosed.

Free cash flow

provides additional insight computed by subtracting capital expenditures and cash dividends from cash provided by operations

Consistency

Company uses same accounting methods from year to year.

statement of cash flows

Operating activities Investing activities Financing activities

Materiality

Relates to a financial statement item's impact on a company's overall financial condition and operations. An item is material if it can influence the decision of an investor or a creditor. Companies do not have to follow GAAP for small amounts.

CHARACTERISTICS OF USEFUL INFORMATION

Relevance Reliability Comparability Consistency

Property, Plant, and Equipment

1.Assets with relatively long useful lives. 2.Assets used in the business. 3.Examples include land, buildings, machinery, delivery equipment, and furniture and fixtures. 4.Most property, plant, and equipment assets are depreciated, and charged to the income statement as an expense, to indicate their contribution to the revenue-producing process for the period. Land is not depreciated.

Operating activities

1.Cash inflows and cash outflows associated with the primary operations of the business. 2.Intended to indicate the cash-generating capability of a company.

Current ratio

1.Measure of short-term ability to pay obligations. 2.Computed by dividing current assets by current liabilities. 3.More dependable indicator of liquidity than working capital. 4.Does not take into account composition of current assets.

Working capital

1.Measure of short-term ability to pay obligations. 2.Excess of current assets over current liabilities. 3.Positive workng capital indicates the likelihood for paying liabilities is favorable.

Debt to total assets ratio

1.Measures the percentage of assets financed by creditors. 2.The higher the percentage of debt financing, the riskier the business. 3.Computed by dividing total debt (both current and long-term liabilities) by total assets.

Long-Term Liabilities

1.Obligations expected to be paid after one year. 2.Liabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and obligations under employee pension plans.

Current Liabilities

1.Obligations that are supposed to be paid within the coming year. 2.Common examples are accounts payable, wages payable, bank loans payable, interest payable, taxes payable, and current maturities of long-term bank loans payable.

Intangible Assets

1.Rights, privileges, and competitive advantages. 2.Non-current assets which have no physical substance. 3.Examples are franchises, patents, copyrights, and trademarks or trade names. 4.Some intangible assets are amortized, and charged to the income statement as an expense, to indicate their contribution to the revenue-producing process for the period.

Statement of Stockholders' Equity

1.issuance of common stock 2.retirement of common stock 3.changes in retained earnings

A classified balance sheet helps users evaluate

1.the company's ability to pay its debts 2.the claims of short-term and long-term creditors

Conservatism

Allows the accountant to choose the accounting method that will be the least likely to overstate assets and income. Requires that companies write down inventory to market value if it is below cost Requires that when the market value of inventory exceeds cost, the inventory is not increased but instead it is kept at cost.

Time period assumption

Allows the life of the business to be divided into artificial time periods. These periods can be months, quarters, semi-annual periods, or annual periods as required by the business to evaluate its operations.

Retained Earnings Statement

Describes the events that caused changes in retained earnings for the period. Add net income and subtract dividends from beginning balance of retained earnings to arrive at ending balance of retained earnings.

Cost principle

Dictates that assets be recorded at their cost

Comparability

Different companies use similar accounting principles.

Economic entity assumption

Every economic entity can be separately identified and accounted for.

A ratio

Expresses the mathematical relationship between one quantity and another

Ratio Analysis

Expresses the relationship among selected items

RELIABILITY

If information can be depended on, it is reliable. Is verifiable Is a faithful representation Is neutral

Monetary unit assumption

Include in the accounting records only those things that can be expressed in terms of money.

CONSTRAINTS

Materiality Conservatism

To develop accounting standards, the FASB relies on some key assumptions and principles.

Monetary Unit Assumption Economic Entity Assumption Time Period Assumption Going Concern Assumption Cost Principle Full Disclosure Principle

Generally Accepted Accounting Principles

are the agreed-upon accounting rules which most U. S. companies use in preparing financial statements. The Securities and Exchange Commission (SEC) oversees U.S. financial markets and standard-setting. The Public Company Accounting Oversight Board (PCAOB) determines auditing standards and reviews auditing firms. In the U.S., the Financial Accounting Standards Board (FASB) is the primary standard-setting body. The International Accounting Standards Board (IASB) issues standards (IFRS) that have been adopted by many countries outside the United States.

Fails to take into account that a company must

invest in new property, plant, and equipment to maintain its current level of operations and maintain dividends at current levels to satisfy investors.

Stockholders' Equity

the stockholders' net claim on total assets. It has two components, common stock and retained earnings