book ch.1-7
ataylor8482
study objectives
After studying this chapter, you should be able to:
1 Identify the sections of a classified balance sheet.
2 Identify and compute ratios for analyzing a company’s profitability.
3 Explain the relationship between a retained earnings state- ment and a statement of stockholders’ equity.
4 Identify and compute ratios for analyzing a company’s liquidity and solvency using a balance sheet.
5 Use the statement of cash flows to evaluate solvency.
6 Explain the meaning of generally accepted accounting principles.
7 Discuss financial reporting concepts.
INSIDE CHAPTER 2…
chapter
A FURTHER LOOK AT FINANCIAL STATEMENTS
2
46
● Scan Study Objectives
● Read Feature Story
● Scan Preview
● Read Text and Answer p. 52 p. 53 p. 62 p. 68
● Work Using the Decision Toolkit
● Review Summary of Study Objectives
● Work Comprehensive p. 72
● Answer Self-Test Questions
● Complete Assignments
● Go to WileyPLU S for practice and tutorials
● Read A Look at I FR S p. 96
● the navigator
Do it!
Do it!
✓
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 46
47
Few people could have predicted how dramatically the Internet would change the investment world. One of the most interesting results is how it has changed the way ordinary people invest their savings. More and more people are striking out on their own, making their own investment decisions.
Two early pioneers in providing investment infor- mation to the masses were Tom and David Gardner, brothers who created an online investor bulletin board called The Motley Fool. The name comes from Shakespeare’s As You Like It. The fool in Shakespeare’s plays was the only one who could speak unpleasant truths to kings and queens without being killed. Tom and David view themselves as 21st- century “fools,” revealing the “truths” of Wall Street to the small investor, who they feel has been taken ad- vantage of by Wall Street insiders. Their online bulletin board enables investors to exchange information and insights about companies.
Critics of these bulletin boards contend that they are high-tech rumor mills. They suggest that the fervor created by bulletin board chatter causes investors to bid up stock prices to unreasonable levels. Because bulletin board participants typically use aliases, there is little to stop people from putting misinformation on the board to influence a stock’s price. For example, the stock of PairGain Technologies jumped 32 percent in a single day as a result of a bogus takeover rumor on an investment bulletin board. Some observers are concerned that small investors—ironically, the very peo- ple the Gardner brothers are trying to help—will be hurt the most by misinformation and intentional scams.
To show how these bulletin boards work, suppose that in a re- cent year you had $10,000 to invest. You were con- sidering Best Buy Company, the largest seller of elec- tronics equipment in the United States. You scanned the Internet investment bulletin boards and found mes- sages posted by two different investors. Here are
excerpts from actual postings during the same year:
TMPVenus: “Where are the prospects
for positive movement for this com-
pany? Poor margins, poor management,
astronomical P/E!”
broachman: “I believe that this is a LONG TERM
winner, and presently at a good price.”
One says sell, and one says buy. Whom should you believe? If you had taken “broachman’s” advice and purchased the stock, the $10,000 you invested would have been worth over $300,000 five years later. Best Buy was one of America’s best-performing stocks during that period of time.
Deciding what information to rely on is becoming increasingly complex. For example, shortly before its share price completely collapsed, nearly every profes- sional analyst who followed Enron was recommending its stock as a “buy.”
Rather than getting swept away by rumors, investors must sort out the good information from the bad. One thing is certain—as information services such as The Motley Fool increase in number, gathering information will become even easier. Evaluating it will be the harder task.
J U S T F O O L I N G A R O U N D ?
feature story
● Can a Company Be Too Liquid? (p. 60) ● When Debt Is Good (p. 61) ● The Korean Discount (p. 64) ● What Do These Companies Have in Common? (p. 65)
INSIDE CHAPTER 2 . . .
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 47
A Further Look At Financial Statements
If you are thinking of purchasing Best Buy stock, or any stock, how can you decide what the stock is worth? If you manage J. Crew’s credit department, how should you determine whether to extend credit to a new cus- tomer? If you are a financial executive of IBM, how do you decide whether your company is generating ade- quate cash to expand operations without borrowing? Your decision in each of these situations will be influenced by a variety of considerations. One of them should be your careful analysis of a company’s financial statements. The reason: Financial statements offer relevant and reliable information, which will help you in your decision making.
In this chapter, we take a closer look at the balance sheet and introduce some useful ways for evaluating the information provided by the financial statements. We also examine the financial reporting concepts under- lying the financial statements.
In Chapter 1, we introduced the four financial statements. In this section, we review the financial statements and present tools that are useful for evaluating them. We begin by introducing the classified balance sheet.
The Classified Balance Sheet In Chapter 1, you learned that a balance sheet presents a snapshot of a com- pany’s financial position at a point in time. The balance sheet in Chapter 1 listed individual asset, liability and stockholders’ equity items in no particular order. To improve users’ understanding of a company’s financial position, companies often use a classified balance sheet. A classified balance sheet 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 clas- sifications listed in Illustration 2-1.
preview of chapter 2
• Current assets • Long-term investments • Property, plant, and equipment • Intangible assets • Current liabilities • Long-term liabilities • Stockholders’ equity
The Classified Balance Sheet
• Ratio analysis • Using the income statement • Using the statement of stockholders’
equity • Using a classified balance sheet • Using the statement of cash flows
Using the Financial Statements
• The standard-setting environment • Qualities of useful information • Assumptions • Principles • Constraints
Financial Reporting Concepts
1 Identify the sections of a classified balance sheet.
48
Illustration 2-1 Standard balance sheet classifications Assets Liabilities and Stockholders’ Equity
Current assets Current liabilities Long-term investments Long-term liabilities Property, plant, and equipment Stockholders’ equity Intangible assets
These groupings help readers determine such things as (1) whether the com- pany has enough assets to pay its debts as they come due, and (2) the claims of short- and long-term creditors on the company’s total assets. Many of these
study objective
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 48
groupings can be seen in the balance sheet of Franklin Corporation shown in Illustration 2-2. In the sections that follow, we explain each of these groupings.
CURRENT ASSETS
Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2-2, Franklin Corporation had current assets of $22,100. For most businesses, the cutoff for classification as current assets is one year from the balance sheet date. For example, accounts receivable are current assets because the company will
The Classified Balance Sheet 49
Illustration 2-2 Classified balance sheetFRANKLIN CORPORATION
Balance Sheet October 31, 2012
Assets
Current assets Cash $ 6,600 Short-term investments 2,000 Accounts receivable 7,000 Notes receivable 1,000 Inventory 3,000 Supplies 2,100 Prepaid insurance 400
Total current assets $22,100
Long-term investments Investment in stock of Walters Corp. 5,200 Investment in real estate 2,000 7,200
Property, plant, and equipment Land 10,000 Equipment $24,000 Less: Accumulated
depreciation—equipment 5,000 19,000 29,000 Intangible assets
Patents 3,100
Total assets $61,400
Liabilities and Stockholders’ Equity
Current liabilities Notes payable $11,000 Accounts payable 2,100 Salaries and wages payable 1,600 Unearned sales revenue 900 Interest payable 450
Total current liabilities $16,050
Long-term liabilities Mortgage payable 10,000 Notes payable 1,300
Total long-term liabilities 11,300
Total liabilities 27,350
Stockholders’ equity Common stock 14,000 Retained earnings 20,050
Total stockholders’ equity 34,050
Total liabilities and stockholders’ equity $61,400
Helpful Hint Recall that the accounting equation is Assets � Liabilities � Stockholders’ Equity.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 49
50 chapter 2 A Further Look at Financial Statements
collect them and convert them to cash within one year. Supplies is a current as- set because the company expects to use them up in operations within one year.
Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year. The operating cycle of a company is the average time that it takes 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. But, for some businesses, such as vine- yards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long-term.
Common types of current assets are (1) cash, (2) short-term investments (such as short-term U.S. government securities), (3) receivables (notes receiv- able, accounts receivable, and interest receivable), (4) inventories, and (5) pre- paid expenses (insurance and supplies). Companies list current assets in the order in which they expect to convert them into cash. Follow this rule when doing your homework.
Illustration 2-3 presents the current assets of Southwest Airlines Co. in a re- cent year.
Illustration 2-3 Current assets section SOUTHWEST AIRLINES CO.
Balance Sheet (partial) (in millions)
Current assets Cash and cash equivalents $1,390 Short-term investments 369 Accounts receivable 241 Inventories 181 Prepaid expenses and other current assets 420
Total current assets $2,601
As explained later in the chapter, a company’s current assets are important in assessing its short-term debt-paying ability.
LONG-TERM INVESTMENTS
Long-term investments are generally: (1) investments in stocks and bonds of other corporations that are held for more than one year, and (2) long-term as- sets such as land or buildings that a company is not currently using in its oper- ating activities. In Illustration 2-2, Franklin Corporation reported total long-term investments of $7,200 on its balance sheet.
Yahoo! Inc. reported long-term investments on its balance sheet in a recent year as shown in Illustration 2-4.
Alternative Terminology Long- term investments are often referred to simply as investments.
Illustration 2-4 Long- term investments section YAHOO! INC.
Balance Sheet (partial) (in thousands)
Long-term investments Long-term investments in marketable securities $90,266
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 50
PROPERTY, PLANT, AND EQUIPMENT
Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business. This category includes land, build- ings, equipment, delivery vehicles, and furniture. In Illustration 2-2, Franklin Corporation reported property, plant, and equipment of $29,000.
Depreciation is the practice of allocating the cost of assets 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). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation. The accumulated depre- ciation account shows the total amount of depreciation that the company has expensed thus far in the asset’s life. In Illustration 2-2, Franklin Corporation reported accumulated depreciation of $5,000.
Illustration 2-5 presents the property, plant, and equipment of Cooper Tire & Rubber Company in a recent year.
The Classified Balance Sheet 51
Alternative Terminology Property, plant, and equipment is sometimes called fixed assets or plant assets.
International Note In 2007, China adopted International Financial Reporting Standards (IFRS). This was done in an effort to reduce fraud and increase investor confidence in financial reports. Under these standards, many items, such as property, plant, and equipment, may be reported at current fair values, rather than historical cost.
Illustration 2-5 Property, plant, and equipment section
COOPER TIRE & RUBBER COMPANY Balance Sheet (partial)
(in thousands)
Property, plant, and equipment Land and land improvements $ 41,553 Buildings 298,706 Machinery and equipment 1,636,091 Molds, cores, and rings 268,158 $2,244,508
Less: Accumulated depreciation 1,252,692
$ 991,816
INTANGIBLE ASSETS
Many companies have assets that do not have physical substance 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. Franklin Corporation reported intangible assets of $3,100.
Illustration 2-6 shows the intangible assets of media giant Time Warner, Inc. in a recent year.
Helpful Hint Sometimes intangible assets are reported under a broader heading called “Other assets.”
Illustration 2-6 Intangible assets sectionTIME WARNER, INC.
Balance Sheet (partial) (in millions)
Intangible assets Goodwill $40,953 Film library 2,690 Customer lists 2,540 Cable television franchises 38,048 Sports franchises 262 Brands, trademarks, and other intangible assets 8,313
$92,806
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 51
52 chapter 2 A Further Look at Financial Statements
CURRENT LIABILITIES
In the liabilities and stockholders’ equity section of the balance sheet, the first grouping is current liabilities. Current liabilities are obligations that the com- pany is to pay within the coming year or operating cycle, whichever is longer. Common examples are accounts payable, wages payable, bank loans payable, interest payable, and taxes payable. Also included as current liabilities are cur- rent maturities of long-term obligations—payments to be made within the next year on long-term obligations. In Illustration 2-2, Franklin Corporation reported five different types of current liabilities, for a total of $16,050.
Within the current liabilities section, companies usually list notes payable first, followed by accounts payable. Other items then follow in the order of their magnitude. In your homework, you should present notes payable first, followed by accounts payable.
Illustration 2-7 shows the current liabilities section adapted from the bal- ance sheet of Marcus Corporation in a recent year.
LONG-TERM LIABILITIES
Long-term liabilities 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 re- port 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
Baxter Hoffman recently received the following information related to Hoffman Corporation’s December 31, 2012, balance sheet.
Prepaid insurance $ 2,300 Inventory $3,400 Cash 800 Accumulated depreciation— Equipment 10,700 equipment 2,700
Accounts receivable 1,100
Prepare the assets section of Hoffman Corporation’s balance sheet.
Solution
ASSETS SECTION OF BALANCE SHEET
before you go on...
Do it!
Action Plan
• Present current assets first. Current assets are cash and other resources that the company expects to convert to cash or use up within one year.
• Present current assets in the order in which the company expects to convert them into cash.
• Subtract accumulated depreciation —equipment from equipment to determine net equipment.
Assets Current assets
Cash $ 800 Accounts receivable 1,100 Inventory 3,400 Prepaid insurance 2,300
Total current assets $ 7,600
Equipment 10,700 Less: Accumulated depreciation—
equipment 2,700 8,000
Total assets $15,600
HOFFMAN CORPORATION Balance Sheet (partial) December 31, 2012
Related exercise material: BE2-2, 2-1, and E2-4.Do it!
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 52
The Classified Balance Sheet 53
MARCUS CORPORATION Balance Sheet (partial)
(in thousands)
Current liabilities Notes payable $ 239 Accounts payable 24,242 Current maturities of long-term debt 57,250 Other current liabilities 27,477 Taxes payable 11,215 Accrued compensation payable 6,720
Total current liabilities $127,143
Illustration 2-8 Long- term liabilities sectionTHE PROCTER & GAMBLE COMPANY
Balance Sheet (partial) (in millions)
Long-term liabilities Long-term debt $23,375 Deferred income taxes 12,015 Other noncurrent liabilities 5,147
Total long-term liabilities $40,537
statements. Others list the various types of long-term liabilities. In Illustration 2-2, Franklin Corporation reported long-term liabilities of $11,300.
Illustration 2-8 shows the long-term liabilities that The Procter & Gamble Company reported in its balance sheet in a recent year.
BALANCE SHEET CLASSIFICATIONS
before you go on...
Do it! The following financial statement items were taken from the financial
statements of Callahan Corp.
______ Salaries and wages payable ______ Equipment ______ Service revenue ______ Accumulated depreciation— ______ Interest payable equipment ______ Goodwill ______ Depreciation expense ______ Short-term investments ______ Retained earnings ______ Mortgage payable (due in 3 years) ______ Unearned service revenue ______ Investment in real estate
Alternative Terminology Common stock is sometimes called capital stock.
Illustration 2-7 Current liabilities section
STOCKHOLDERS’ EQUITY
Stockholders’ equity consists of two parts: common stock and retained earnings. Companies record as common stock the investments of assets into the business by the stockholders. They record as retained earnings the income retained for use in the business. These two parts, combined, make up stockholders’ equity on the balance sheet. In Illustration 2-2, Franklin reported common stock of $14,000 and retained earnings of $20,050.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 53
54 chapter 2 A Further Look at Financial Statements
Using the Financial Statements In Chapter 1, we introduced the four financial statements. We discussed how these statements provide information about a company’s performance and finan- cial position. In this chapter, we extend this discussion by showing you specific tools that you can use to analyze financial statements in order to make a more meaningful evaluation of a company.
RATIO ANALYSIS
Ratio analysis expresses the relationship among selected items of financial state- ment data. A ratio expresses the mathematical relationship between one quan- tity and another. For analysis of the primary financial statements, we classify ratios as follows.
Match each of the items to its proper balance sheet classification, shown below. If the item would not appear on a balance sheet, use “NA.”
Current assets (CA) Current liabilities (CL) Long-term investments (LTI) Long-term liabilities (LTL) Property, plant, and equipment (PPE) Stockholders’ equity (SE) Intangible assets (IA)
Solution
CL Salaries and wages payable LTI Investment in real estate NA Service revenue PPE Equipment CL Interest payable PPE Accumulated depreciation— IA Goodwill equipment CA Short-term investments NA Depreciation expense LTL Mortgage payable SE Retained earnings
(due in 3 years) CL Unearned service revenue
Action Plan
• Analyze whether each financial statement item is an asset, liability, or stockholders’ equity item.
• Determine if asset and liability items are current or long-term.
Illustration 2-9 Financial ratio classifications
Liquidity Ratios
Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash
Profitability Ratios
Measure the income or operating success of a company for a given period of time
Solvency Ratios
Measure the ability of the company to survive over a long period of time
– = Net
incomeRevenues Expenses
XYZ Co.
Founded in 1892
Related exercise material: BE2-1, 2-2, E2-1, E2-2, E2-3, E2-5 and E2-6.Do it!
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 54
A single ratio by itself is not very meaningful. Accordingly, in this and the following chapters, we will use various comparisons to shed light on company performance:
1. Intracompany comparisons covering two years for the same company.
2. Industry-average comparisons based on average ratios for particular industries.
3. Intercompany comparisons based on comparisons with a competitor in the same industry.
USING THE INCOME STATEMENT
Best Buy Company generates profits for its stockholders by selling electronics. The income statement reports how successful it is at generating a profit from its sales. The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses). Illustration 2-10 shows a simplified income statement for Best Buy.
Using the Financial Statements 55
2 Identify and compute ratios for analyzing a company’s profitability.
Illustration 2-10 Best Buy’s income statementBEST BUY CO., INC.
Income Statements For the Years Ended February 28, 2009,
and March 1, 2008 (in millions)
2009 2008 Revenues Net sales and other revenue $45,015 $40,023
Expenses Cost of goods sold 34,017 30,477 Selling, general, and
administrative expenses and other 9,321 7,324 Income tax expense 674 815
Total expenses 44,012 38,616
Net income $ 1,003 $ 1,407
From this income statement, we can see that Best Buy’s sales increased but net income decreased during the period. Net income decreased from $1,407 mil- lion to $1,003 million. A much smaller competitor of Best Buy is hhgregg. It op- erates 111 stores in 9 states and is headquartered in Indianapolis, Indiana. It re- ported net income of $36.5 million for the year ended March 31, 2009.
To evaluate the profitability of Best Buy, we will use ratio analysis. Prof- itability ratios measure the operating success of a company for a given period of time.
Earnings per Share Earnings per share (EPS) measures the net income earned on each share of common stock. We compute EPS by dividing net income by the average num- ber of common shares outstanding during the year. Stockholders usually think in terms of the number of shares they own or plan to buy or sell, so stat- ing net income earned as a per share amount provides a useful perspective for determining the investment return. Advanced accounting courses present more refined techniques for calculating earnings per share.
study objective
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 55
56 chapter 2 A Further Look at Financial Statements
For now, a basic approach for calculating earnings per share is to divide earnings available to common stockholders by average common shares out- standing during the year. What is “earnings available to common stockhold- ers”? It is an earnings amount calculated as net income less dividends paid on another type of stock, called preferred stock (Net income � Preferred stock dividends).
By comparing earnings per share of a single company over time, one can evaluate its relative earnings performance from the perspective of a stock- holder—that is, on a per share basis. It is very important to note that com- parisons of earnings per share across companies are not meaningful because of the wide variations in the numbers of shares of outstanding stock among companies.
Illustration 2-11 shows the earnings per share calculation for Best Buy in 2009 and 2008, based on the information presented below. (Note that to sim- plify our calculations, we assumed that any change in the number of shares for Best Buy occurred in the middle of the year.)
(in millions) 2009 2008
Net income $1,003 $1,407 Preferred stock dividends –0– –0– Shares outstanding at beginning of year 411 481 Shares outstanding at end of year 414 411
Illustration 2-11 Best Buy’s earnings per share Earnings per
� Net Income � Preferred Stock Dividends
Share Average Common Shares Outstanding
Earnings per share $1,003 � $0 � $2.43 $1,407 � $0 � $3.15
(414 � 411)/2 (411 � 481)/2
($ and shares in millions) 2009 2008
DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
How does the company’s earnings performance compare with that of previous years?
Net income available to common stockholders and average common shares outstanding
A higher measure suggests improved performance, although the number is subject to manipulation. Values should not be compared across companies.
INFO NEEDED FOR DECISION
DECISION TOOLKIT
Earnings per share
Net income � Preferred stock dividends Average common shares outstanding
�
USING THE STATEMENT OF STOCKHOLDERS’ EQUITY
As discussed in Chapter 1, the retained earnings statement describes the changes in retained earnings during the year. This statement adds net income and then subtracts dividends from the beginning retained earnings to arrive at ending re- tained earnings.
Stockholders’ equity is comprised of two parts: retained earnings and com- mon stock. Therefore, the stockholders’ equity of most companies is affected by factors other than just changes in retained earnings. For example, the company
3 Explain the relationship between a retained earnings statement and a statement of stockholders’ equity.
study objective
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 56
may issue or retire shares of common stock. Most companies, therefore, use what is called a statement of stockholders’ equity, rather than a retained earn- ings statement, so that they can report all changes in stockholders’ equity accounts. Illustration 2-12 is a simplified statement of stockholders’ equity for Best Buy.
Using the Financial Statements 57
Illustration 2-12 Best Buy’s statement of stockholders’ equity
BEST BUY CO., INC. Statement of Stockholders’ Equity
(in millions)
Common Retained Stock Earnings
Balances at March 3, 2007 $ 478 $5,723 Issuance of common stock 268 Repurchase of common stock (697) Net income 1,407 Dividends (204) Other adjustments (2,491)
Balances at March 1, 2008 49 4,435 Issuance of common stock 197 Net income 1,003 Dividends (222) Other adjustments (819)
Balances at February 28, 2009 $ 246 $4,397
We can observe from this financial statement that Best Buy’s common stock decreased during the first year. Even though it had an issuance of common stock, that increase was much smaller than the decrease caused by a stock repurchase. It increased in the second year as the result of an issuance of shares. Another observation from this financial statement is that Best Buy paid dividends each year. This is a relatively recent practice for Best Buy. Prior to 2003, it did not pay dividends, even though it was profitable and could do so. You might won- der why Best Buy paid no dividends during prior years when it was profitable. In fact, in a prior year, two Best Buy stockholders discussed this question about the company’s dividend policy on an investor bulletin board. Here are excerpts:
Katwoman: “Best Buy has a nice price increase. Earnings are on the way up. But why no dividends?”
AngryCandy: “I guess they feel they can make better use of the money by investing back in the business.They still view Best Buy as a rapidly growing company and would prefer to invest in expanding the infrastructure (building new stores, advertising, etc.) than in paying out dividends. . . . If Best Buy gets to the stage of ‘stable, big company’ with little room for expansion, then I’m sure you’ll see them elect to pay out a dividend.”
AngryCandy’s response is an excellent explanation of the thought process that management goes through in deciding whether to pay a dividend. Manage- ment must evaluate what its cash needs are. If it has uses for cash that will increase the value of the company (for example, building a new, centralized warehouse), then it should retain cash in the company. However, if it has more cash than it has valuable opportunities, it should distribute its excess cash as a dividend.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 57
58 chapter 2 A Further Look at Financial Statements
USING A CLASSIFIED BALANCE SHEET
You can learn a lot about a company’s financial health by also evaluating the re- lationship between its various assets and liabilities. Illustration 2-13 provides a simplified balance sheet for Best Buy.
4 Identify and compute ratios for analyzing a company’s liquidity and solvency using a balance sheet.
Illustration 2-13 Best Buy’s balance sheet BEST BUY CO., INC.
Balance Sheets (in millions)
Assets February 28, 2009 March 1, 2008
Current assets Cash and cash equivalents $ 498 $ 1,438 Short-term investments 11 64 Receivables 1,868 549 Merchandise inventories 4,753 4,708 Other current assets 1,062 583
Total current assets 8,192 7,342
Property and equipment 6,940 5,608 Less: Accumulated depreciation 2,766 2,302
Net property and equipment 4,174 3,306
Other assets 3,460 2,110
Total assets $15,826 $12,758
Liabilities and Stockholders’ Equity
Current liabilities Accounts payable $ 4,997 $ 4,297 Accrued liabilities 1,382 975 Accrued income taxes 281 404 Accrued compensation payable 459 373 Other current liabilities 1,316 720
Total current liabilities 8,435 6,769
Long-term liabilities Long-term debt 1,126 627 Other long-term liabilities 1,622 878
Total long-term liabilities 2,748 1,505
Total liabilities 11,183 8,274
Stockholders’ equity Common stock 246 49 Retained earnings 4,397 4,435
Total stockholders’ equity 4,643 4,484
Total liabilities and stockholders’ equity $15,826 $12,758
Liquidity Suppose you are a banker at CitiGroup considering lending money to Best Buy, or you are a sales manager at Hewlett-Packard interested in selling computers to Best Buy on credit. You would be concerned about Best Buy’s liquidity—its ability to pay obligations expected to become due within the next year or oper- ating cycle. You would look closely at the relationship of its current assets to current liabilities.
study objective
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 58
WORKING CAPITAL. One measure of liquidity is working capital, which is the difference between the amounts of current assets and current liabilities:
Using the Financial Statements 59
Working Capital � Current Assets � Current Liabilities Illustration 2-14 Working capital
When current assets exceed current liabilities, working capital is positive. When this occurs, there is greater likelihood that the company will pay its li- abilities. When working capital is negative, a company might not be able to pay short-term creditors, and the company might ultimately be forced into bank- ruptcy. Best Buy had working capital in 2009 of �$243 million ($8,192 million � $8,435 million). Best Buy’s negative working capital does not necessarily mean the company has liquidity problems. It does warrant further investigation though.
CURRENT RATIO. Liquidity ratios measure the short-term ability of the com- pany to pay its maturing obligations and to meet unexpected needs for cash. One liquidity ratio is the current ratio, computed as current assets divided by current liabilities.
The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have sig- nificantly different current ratios. Illustration 2-15 shows the 2009 and 2008 cur- rent ratios for Best Buy and for hhgregg, along with the 2009 industry average.
Illustration 2-15 Current ratio
Current Ratio � Current Assets Current Liabilities
Best Buy Industry ($ in millions) hhgregg Average
$8,192 = .97:1 1.08:1 1.68:1 1.50:1
$8,435
2009 2008 2009 2009
What does the ratio actually mean? Best Buy’s 2009 current ratio of .97:1 means that for every dollar of current liabilities, Best Buy has 97¢ of current as- sets. Best Buy’s current ratio decreased in 2009. When compared to the indus- try average of 1.5:1, Best Buy’s liquidity seems low. It is also less than hhgregg’s.
One potential weakness of the current ratio is that it does not take into ac- count the composition of the current assets. For example, a satisfactory cur- rent ratio does not disclose whether a portion of the current assets is tied up in slow-moving inventory. The composition of the current assets matters because a dollar of cash is more readily available to pay the bills than is a dollar of in- ventory. For example, suppose a company’s cash balance declined while its mer- chandise inventory increased substantially. If inventory increased because the company is having difficulty selling its products, then the current ratio might not fully reflect the reduction in the company’s liquidity.
Ethics Note A company that has more current assets than current liabilities can increase the ratio of current assets to current liabilities by using cash to pay off some current liabilities. This gives the appearance of being more liquid. Do you think this move is ethical?
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 59
What can various company managers do to ensure that working capital is man- aged efficiently to maximize net income? (See page 96.)
60 chapter 2 A Further Look at Financial Statements
Solvency Now suppose that instead of being a short-term creditor, you are interested in either buying Best Buy’s stock or extending the company a long-term loan. Long- term creditors and stockholders are interested in a company’s solvency—its abil- ity to pay interest as it comes due and to repay the balance of a debt due at its maturity. Solvency ratios measure the ability of the company to survive over a long period of time.
DEBT TO TOTAL ASSETS RATIO. The debt to total assets ratio is one source of information about long-term debt-paying ability. 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.
We compute the debt to total assets ratio as total debt (both current and long-term liabilities) divided by total assets. The higher the percentage of total liabilities (debt) to total assets, the greater the risk that the company may be un- able to pay its debts as they come due. Illustration 2-16 shows the debt to total assets ratios for Best Buy and hhgregg, along with the 2009 industry average.
Can a Company Be Too Liquid?
There actually is a point where a company can be too liquid—that is, it can have too much working capital. While it is important to be liquid enough to be able to pay short-term bills as they come due, a company does not want to tie up its cash in extra inventory or receivables that are not earning the company money.
By one estimate from the REL Consultancy Group, the thousand largest U.S. com- panies have on their books cumulative excess working capital of $764 billion. Based on this figure, companies could have reduced debt by 36% or increased net income by 9%. Given that managers throughout a company are interested in improving profitabil- ity, it is clear that they should have an eye toward managing working capital. They need to aim for a “Goldilocks solution”—not too much, not too little, but just right.
Source: K. Richardson, “Companies Fall Behind in Cash Management,” Wall Street Journal (June 19, 2007).
Accounting Across the Organization
?
Helpful Hint Some users evaluate solvency using a ratio of liabilities divided by stockholders’ equity. The higher this “debt to equity” ratio, the lower is a company’s solvency.
Illustration 2-16 Debt to total assets ratio
Best Buy Industry ($ in millions) hhgregg Average
$11,183 = 71% 65% 64% 57%
$15,826
2009 2008 2009 2009
Debt to Total Assets Ratio � Total Liabilities Total Assets
The 2009 ratio of 71% means that every dollar of assets was financed by 71 cents of debt. Best Buy’s ratio exceeds the industry average of 57% and is higher than hhgregg’s ratio of 64%. The higher the ratio, the more reliant the company is
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 60
on debt financing. This means the company has a lower equity “buffer” avail- able to creditors if the company becomes insolvent. Thus, from the creditors’ point of view, a high ratio of debt to total assets is undesirable. Best Buy’s sol- vency appears lower than hhgregg’s and lower than the average company in the industry.
The adequacy of this ratio is often judged in the light of the company’s earn- ings. Generally, companies with relatively stable earnings, such as public utili- ties, can support higher debt to total assets ratios than can cyclical companies with widely fluctuating earnings, such as many high-tech companies. In later chapters, you will learn additional ways to evaluate solvency.
Using the Financial Statements 61
When Debt Is Good
Debt financing differs greatly across industries and companies. Here are some debt to total assets ratios for selected companies in a recent year:
Debt to Total Assets Ratio
American Pharmaceutical Partners 19% Callaway Golf Company 20% Microsoft 21% Sears Holdings Corporation 73% Eastman Kodak Company 78% General Motors Corporation 94%
Investor Insight
? Discuss the difference in the debt to total assets ratio of Microsoft and GeneralMotors. (See page 96.)
DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
Can the company meet its near-term obligations?
Current assets and current liabilities
Higher ratio suggests favorable liquidity.
INFO NEEDED FOR DECISION
DECISION TOOLKIT
Current ratio � Current assets Current liabilities
Debt to total �
Total liabilities assets ratio Total assets
Can the company meet its long-term obligations?
Total debt and total assets Lower value suggests favorable solvency.
KEEPING AN EYE ON CASH
In the statement of cash flows, cash provided by operating activities is intended to indicate the cash-generating capability of the company. Analysts have noted, however, that cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment (capi- tal expenditures) just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. A mea- surement to provide additional insight regarding a company’s cash-generating ability is free cash flow. Free cash flow describes the cash remaining from operating activities after adjusting for capital expenditures and dividends paid.
Consider the following example: Suppose that MPC produced and sold 10,000 personal computers this year. It reported $100,000 cash provided by operating
5 Use the statement of cash flows to evaluate solvency.
study objective
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 61
62 chapter 2 A Further Look at Financial Statements
activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash flow was $80,000 ($100,000 � $15,000 � $5,000). The company could use this $80,000 to purchase new assets to expand the business, to pay off debts, or to increase its dividend distribution. In practice, analysts often calculate free cash flow with the formula shown below. (Alternative definitions also exist.)
Free Cash �
Cash Provided �
Capital �
Cash Flow by Operations Expenditures Dividends
We can calculate Best Buy’s 2009 free cash flow as follows (dollars in millions).
Best Buy generated free cash flow of $352 million which is available for the acquisition of new assets, the retirement of stock or debt, or the payment of ad- ditional dividends. Long-term creditors consider a high free cash flow amount an indication of solvency. hhgregg’s free cash flow for 2009 is $7.7 million. Given that hhgregg is considerably smaller than Best Buy, we would expect its free cash flow to be much lower.
Cash provided by operating activities $1,877
Less: Expenditures on property, plant, and equipment 1,303
Dividends paid 222
Free cash flow $ 352
DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
How much cash did the company generate to expand operations, pay off debts, or distribute dividends?
Cash provided by operating activities, cash spent on fixed assets, and cash dividends
Significant free cash flow indicates greater potential to finance new investment and pay additional dividends.
INFO NEEDED FOR DECISION
DECISION TOOLKIT
Free cash flow
Cash provided by operations
Capital expenditures
Cash dividends� � �
The following information is available for Ozone Inc.
2012 2011
Current assets $ 88,000 $ 60,800 Total assets 400,000 341,000 Current liabilities 40,000 38,000 Total liabilities 120,000 150,000 Net income 100,000 50,000 Cash provided by operating activities 110,000 70,000 Preferred stock dividends 10,000 10,000 Common stock dividends 5,000 2,500 Expenditures on property, plant, and equipment 45,000 20,000
Shares outstanding at beginning of year 60,000 40,000 Shares outstanding at end of year 120,000 60,000
RATIO ANALYSIS
before you go on...
Do it!
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 62
Financial Reporting Concepts In Chapter 1, you learned about the four financial statements, and in this chap- ter, we introduced you to some basic ways to interpret those statements. In this last section, we will discuss concepts that underly these financial statements. It would be unwise to make business decisions based on financial statements with- out understanding the implications of these concepts.
THE STANDARD-SETTING ENVIRONMENT
How does Best Buy decide on the type of financial information to disclose? What format should it use? How should it measure assets, liabilities, revenues, and expenses? Best Buy and all other U.S. companies get guidance from a set of rules and practices that have authoritative support, referred to as generally accepted accounting principles (GAAP). Standard-setting bodies, in consultation with the accounting profession and the business community, determine these account- ing standards.
Financial Reporting Concepts 63
(a) Compute earnings per share for 2012 and 2011 for Ozone, and comment on the change. Ozone’s primary competitor, Frost Corporation, had earnings per share of $2 in 2012. Comment on the difference in the ratios of the two companies.
(b) Compute the current ratio and debt to total assets ratio for each year, and comment on the changes.
(c) Compute free cash flow for each year, and comment on the changes.
Solution
(a) Earnings per share
Ozone’s profitability, as measured by the amount of income available to each share of common stock, increased by 25% [($1.00 � $0.80) � $0.80] during 2012. Earnings per share should not be compared across companies because the number of shares issued by companies varies widely. Thus, we cannot conclude that Frost Corporation is more prof- itable than Ozone based on its higher EPS.
(b)
Current ratio
2011
($50,000 � $10,000) � $0.80
(60,000 � 40,000)/2
2012
($100,000 � $10,000) � $1.00
(120,000 � 60,000)/2
2012
$88,000 � 2.20:1 $40,000
2011
$60,800 �1.60:1 $38,000
Debt to total assets ratio $120,000 � 30% $400,000
$150,000 � 44% $341,000
The company’s liquidity, as measured by the current ratio, improved from 1:60:1 to 2.20:1. Its solvency also improved, as measured by the debt to total assets ratio, which declined from 44% to 30%.
(c) Free cash flow
2012: $110,000 � $45,000 � ($10,000 � $5,000) � $50,000 2011: $70,000 � $20,000 � ($10,000 � $2,500) � $37,500
The amount of cash generated by the company above its needs for dividends and capi- tal expenditures increased from $37,500 to $50,000.
Action Plan
• Use the formula for earnings per share (EPS): (Net income � Preferred stock dividends) � (Average common shares outstanding).
• Use the formula for the current ratio: Current assets � Current liabilities.
• Use the formula for the debt to total assets ratio: Total liabilities � Total assets.
• Use the formula for free cash flow: Cash provided by operating activities � Capital expenditures � Cash dividends.
6 Explain the meaning of generally accepted accounting principles.
study objective
Related exercise material: BE2-3, BE2-5, BE2-6, 2-3, E2-7, E2-9, E2-10, and E2-11.Do it!
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 63
64 chapter 2 A Further Look at Financial Statements
The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. financial markets and accounting standard- setting bodies. The Financial Accounting Standards Board (FASB) is the pri- mary accounting standard-setting body in the United States. The International Accounting Standards Board (IASB) issues standards called International Financial Reporting Standards (IFRS), which have been adopted by many countries outside of the United States. Today, the FASB and IASB are working closely together to minimize the differences in their standards. Recently, the SEC announced that foreign companies that wish to have their shares traded on U.S stock exchanges no longer have to prepare reports that conform with GAAP, as long as their reports conform with IFRS. The SEC is currently eval- uating whether the United States should eventually adopt IFRS as the required set of standards for U.S. publicly traded companies. Another relatively recent change to the financial reporting environment was that, as a result of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) was created. Its job is to determine auditing standards and review the perform- ance of auditing firms. If the United States adopts IFRS for its accounting stan- dards, it will also have to coordinate its auditing regulations with those of other countries.
International Note Over 100 countries use international standards (called IFRS). For example, all companies in the European Union follow international standards. The differences between U.S. and international standards are not generally significant. In this book, we highlight any major differences using International Notes like this one, as well as a more in- depth discussion in the A Look at IFRS section at the end of each chapter.
7 Discuss financial reporting concepts.
The Korean Discount
If you think that accounting standards don’t matter, consider recent events in South Korea. For many years, international investors complained that the financial reports of South Korean companies were inadequate and inaccurate. Accounting prac- tices there often resulted in huge differences between stated revenues and actual rev- enues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of com- parable companies in different countries. This difference in share price was often re- ferred to as the “Korean discount.”
In response, Korean regulators decided that, beginning in 2011, companies will have to comply with international accounting standards. This change was motivated by a de- sire to “make the country’s businesses more transparent” in order to build investor con- fidence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international standards or to create standards that are based on the international standards.
Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).
International Insight
? What is meant by the phrase “make the country’s businesses more transparent”?Why would increasing transparency spur economic growth? (See page 96.)
QUALITIES OF USEFUL INFORMATION
Recently, the FASB and IASB completed the first phase of a joint project in which they developed a conceptual framework to serve as the basis for future account- ing standards. The framework begins by stating that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 2-17.
study objective
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 64
Enhancing Qualities In addition to the two fundamental qualities, the FASB and IASB also describe a number of enhancing qualities of useful information. These include compara- bility, consistency, verifiability, timeliness, and understandability. In account- ing, comparability results when different companies use the same accounting principles. Another characteristic that enhances comparability is consistency. Consistency means that a company uses the same accounting principles and methods from year to year. Information is verifiable if we are able to prove that it is free from error. As noted in Chapter 1, certified public accountants (CPAs) perform audits of financial statements to verify their accuracy. For accounting information to be relevant, it must be timely. That is, it must be available to de- cision makers before it loses its capacity to influence decisions. The SEC requires that public companies provide their annual reports to investors within 60 days of their year-end. Information has the quality of understandability if it is pre- sented in a clear and concise fashion, so that reasonably informed users of that information can interpret it and comprehend its meaning.
Financial Reporting Concepts 65
Illustration 2-17 Fundamental qualities of useful informationRelevance Accounting information is considered relevant 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.BIGSHOT
Tell me what I need to know.
Faithful Representation Faithful representation means that information accurately depicts what really happened. To provide a faithful representation, information must be complete (nothing important has been omitted) and neutral (is not biased toward one position or another).
What Do These Companies Have in Common?
Another issue related to comparability is the accounting time period. An ac- counting period that is one-year long is called a fiscal year. But a fiscal year need not match the calendar year. For example, a company could end its fiscal year on April 30, rather than December 31.
Why do companies choose the particular year-ends that they do? For example, why doesn’t every company use December 31 as the accounting year-end? Many compa- nies choose to end their accounting year when inventory or operations are at a low point. This is advantageous because compiling accounting information requires much time and effort by managers, so they would rather do it when they aren’t as busy operating the business. Also, inventory is easier and less costly to count when its volume is low.
Some companies whose year-ends differ from December 31 are Delta Air Lines, June 30; Walt Disney Productions, September 30; and Dunkin’ Donuts, Inc., October 31. In the notes to its financial statements, Best Buy states that its accounting year-end is the Saturday nearest the end of February.
Accounting Across the Organization
? What problems might Best Buy’s year-end create for analysts? (See page 96.)
c02AFurtherLookatFinancialStatements.qxd 9/6/10 11:59 AM Page 65
66 chapter 2 A Further Look at Financial Statements
ASSUMPTIONS IN FINANCIAL REPORTING
To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 2-18. These include assumptions about the monetary unit, economic entity, periodicity, going concern, and accrual basis.
Ethics Note The importance of the economic entity assumption is illustrated by scandals involving Adelphia. In this case, senior company employees entered into transactions that blurred the line between the employees’ financial interests and those of the company. For example, Adelphia guaranteed over $2 billion of loans to the founding family.
Illustration 2-18 Key assumptions in financial reporting Monetary Unit Assumption The monetary unit
assumption 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.
Acct.Records-Salaries paidMeasure of employee satisfaction
Salaries paid
Total number of employees
Percent of international employees
Economic Entity Assumption The 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 that we not blur company transactions with personal transactions (especially those of its managers) or transactions of other companies.
Chrysler
Ford
GM
FORD
CHRYSLER
G eneral Motors
Periodicity Assumption 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. The 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.
Start of business
End of business
2004
2006 2008 2010 2012
2014
J F
QTR 1
QTR 2
QTR 3
QTR 4
M A M J J A S O N D
Going Concern Assumption The 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.Now Future
Accrual Basis Accrual-basis accounting means that transactions that change a company’s financial statements are recorded in the periods in which the events occur. Accrual-basis accounting is addressed in more detail in Chapter 4.Purchased paint, painted building, paid employees
P AIN T
We Paint!
P AIN T
P AIN T
Bob's Bait B arnBob's Bait Barn
PRINCIPLES IN FINANCIAL REPORTING
Measurement Principles GAAP generally uses one of two measurement principles, the cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 66
COST PRINCIPLE. The cost principle (or historical 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 re- ported at $30,000.
FAIR VALUE PRINCIPLE. The fair value principle indicates that assets and lia- bilities 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 cer- tain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily avail- able 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 prin- ciple to use, the FASB weighs the factual nature of cost figures versus the rele- vance of fair value. In general, the FASB indicates that most assets must follow the cost principle because market values may not be representationally faithful. Only in situations where assets are actively traded, such as investment securi- ties, is the fair value principle applied.
Full Disclosure Principle The full disclosure principle requires that companies disclose all circumstances and events that would make a difference to financial statement users. If an im- portant 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.
CONSTRAINTS IN FINANCIAL REPORTING
Efforts to provide useful financial information can be costly to a company. There- fore, the profession has agreed upon constraints to ensure that companies ap- ply accounting rules in a reasonable fashion, from the perspectives of both the company and the user. The constraints are the materiality and cost constraints, as shown in Illustration 2-19.
Financial Reporting Concepts 67
Illustration 2-19 Constraints in financial reporting
Materiality Constraint The materiality constraint relates to a financial statement item’s impact on a company’s overall financial condition and operations. An item is material when its size makes it likely to influence the decision of an investor or creditor. It is immaterial if it is too small to impact a decision maker. If the item does not make a difference, the company does not have to follow GAAP in reporting it.
Cost Constraint The cost constraint relates to the fact that providing information is costly. In deciding whether companies should be required to provide a certain type of information, 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.
Costs Benefits
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 67
68 chapter 2 A Further Look at Financial Statements
The following are characteristics, assumptions, principles, or constraints that guide the FASB when it creates accounting standards.
Relevance Periodicity assumption Faithful representation Going concern assumption Comparability Cost principle Consistency Full disclosure principle Monetary unit assumption Materiality constraint Economic entity assumption
Match each item above with a description below.
1. ________ Ability to easily evaluate one company’s results relative to another’s.
2. ________ Belief that a company will continue to operate for the foreseeable future.
3. ________ The judgment concerning whether an item is large enough to matter to deci- sion makers.
4. ________ The reporting of all information that would make a difference to financial statement users.
5. ________ The practice of preparing financial statements at regular intervals.
6. ________ The quality of information that indicates the information makes a differ- ence in a decision.
7. ________ A belief that items should be reported on the balance sheet at the price that was paid to acquire the item.
8. ________ A company’s use of the same accounting principles and methods from year to year.
9. ________ Tracing accounting events to particular companies.
10. ________ The desire to minimize errors and bias in financial statements.
11. ________ Reporting only those things that can be measured in dollars.
Solution
FINANCIAL ACCOUNTING CONCEPTS AND PRINCIPLES
before you go on...
Do it!
1. Comparability 7. Cost principle
2. Going concern assumption 8. Consistency
3. Materiality constraint 9. Economic entity assumption
4. Full disclosure principle 10. Faithful representation
5. Periodicity assumption 11. Monetary unit assumption
6. Relevance
Action Plan
• Understand the need for conceptual guidelines in accounting.
• List the characteristics of useful financial information.
• Review the assumptions, princi- ples, and constraints that comprise the guidelines in accounting.
Related exercise material: BE2-8, BE2-9, BE2-10, BE2-11, 2-4, E2-12, and E2-13.Do it!
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 68
Using the Decision Toolkit 69
In this chapter, we evaluated a home electronics giant, Best Buy. Tweeter Home Entertainment sold consumer electronics products from 154 stores on the East Coast under various names. It specialized in products with high-end features. Tweeter filed for bankruptcy in June 2007 and was acquired by another company in July 2007. Financial data for Tweeter, prior to its bankruptcy, are provided below.
September 30
(amounts in millions) 2006 2005
Current assets $146.4 $158.2 Total assets 258.6 284.0 Current liabilities 107.1 119.0 Total liabilities 190.4 201.1 Total common stockholders’ equity 68.2 82.9 Net income (loss) (16.5) (74.4) Cash provided (used) by operating activities 15.6 (26.7) Capital expenditures (net) 17.4 22.2 Dividends paid 0 0
Average shares of common stock (millions) 25.2 24.6
Instructions Using the data provided, answer the following questions and discuss how these results might have provided an indication of Tweeter’s financial troubles.
1. Calculate the current ratio for Tweeter for 2006 and 2005 and discuss its liquid- ity position.
2. Calculate the debt to total assets ratio and free cash flow for Tweeter for 2006 and 2005 and discuss its solvency.
3. Calculate the earnings per share for Tweeter for 2006 and 2005, and discuss its change in profitability.
4. Best Buy’s accounting year-end was February 28, 2007; Tweeter’s was Septem- ber 30, 2006. How does this difference affect your ability to compare their profitability?
USING THE DECISION TOOLKIT
Solution
1. Current ratio:
2006: $146.4 � $107.1 � 1.37:1 2005: $158.2 � $119.0 � 1.33:1
Tweeter’s liquidity improved slightly from 2005 to 2006, but in both years it would most likely have been considered inadequate. In 2006 Tweeter had only $1.37 in current assets for every dollar of current liabilities. Sometimes larger compa- nies, such as Best Buy, can function with lower current ratios because they have alternative sources of working capital. But a company of Tweeter’s size would normally want a higher ratio.
2. Debt to total assets:
2006: $190.4 � $258.6 � 73.6% 2005: $201.1 � $284.0 � 70.8%
Tweeter’s solvency, as measured by its debt to total assets ratio, declined from 2005 to 2006. Its ratio of 73.6% meant that every dollar of assets was financed by 73.6 cents of debt. For a retailer, this is extremely high reliance on debt. This low solvency suggests Tweeter’s ability to meet its debt payments was questionable.
Free cash flow:
2006: $15.6 � $17.4 � $0 � �$1.8 million 2005: �$26.7 � $22.2 � $0 � �$48.9 million
Tweeter’s free cash flow was negative in both years. The company did not gen- erate enough cash from operations even to cover its capital expenditures, and it
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 69
70 chapter 2 A Further Look at Financial Statements
was not paying a dividend. While this is not unusual for new companies in their early years, it is also not sustainable for very long. Part of the reason that its debt to assets ratio, discussed above, was so high was that it had to borrow money to make up for its deficient free cash flow.
3. Loss per share:
2006: �$16.5 � 25.2 � �$0.65 per share 2005: �$74.4 � 24.6 � �$3.02 per share
Tweeter’s loss per share declined substantially. However, this was little consola- tion for its shareholders, who experienced losses in previous years as well. The company’s lack of profitability, combined with its poor liquidity and solvency, increased the likelihood that it would eventually file for bankruptcy.
4. Tweeter’s income statement covers 7 months not covered by Best Buy’s. Suppose that the economy changed dramatically during this 7-month period, either im- proving or declining. This change in the economy would be reflected in Tweeter’s income statement but would not be reflected in Best Buy’s income statement until the following March, thus reducing the usefulness of a comparison of the income statements of the two companies.
Summary of Study Objectives 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.
2 Identify and compute ratios for analyzing a company’s profitability. Profitability ratios, such as earnings per share (EPS), measure aspects of the operating success of a company for a given period of time.
3 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 pe- riod. A statement of stockholders’ equity presents the factors that changed stockholders’ equity during the period, including those that changed retained earn- ings. Thus, a statement of stockholders’ equity is more inclusive.
4 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 obliga- tions and to meet unexpected needs for cash. Solvency ratios, such as the debt to total assets ratio, measure the ability of a company to survive over a long period.
5 Use the statement of cash flows to evaluate solvency. Free cash flow indicates a company’s ability to gener- ate cash from operations that is sufficient to pay debts, acquire assets, and distribute dividends.
6 Explain the meaning of generally accepted accounting principles. Generally accepted accounting principles
are a set of rules and practices recognized as a gen- eral guide for financial reporting purposes. The basic objective of financial reporting is to provide informa- tion that is useful for decision making.
7 Discuss financial reporting concepts. To be judged use- ful, information should have the primary characteris- tics of relevance and faithful representation. In addi- tion, it should be 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 di- vided into artificial time periods and that meaning- ful accounting reports can be prepared for each pe- riod. The going concern assumption states that the company will continue in operation long enough to carry out its existing objectives and commitments. Accrual-basis accounting means that transactions are recorded in the periods in which the events occur.
The cost principle states that companies should record assets at their cost. The fair value principle indi- cates that assets and liabilities should be reported at fair value. The full disclosure principle requires that compa- nies disclose circumstances and events that matter to fi- nancial statement users.
The major constraints are materi- ality and cost.
c02AFurtherLookatFinancialStatements.qxd 9/2/10 1:35 PM Page 70
Glossary 71
Can the company meet its near-term obligations?
Current assets and current liabilities
Higher ratio suggests favorable liquidity.
Current ratio
Current assets Current liabilities
�
Debt to total assets ratio
Total liabilities Total assets
� Can the company meet its long-term obligations?
Total debt and total assets Lower value suggests favorable solvency.
How much cash did the company generate to expand operations, pay off debts, or distribute dividends?
Cash provided by operating activities, cash spent on fixed assets, and cash dividends
Significant free cash flow indicates greater potential to finance new investment and pay additional dividends.
Free cash flow
Cash provided by operations
� Capital
expenditures �
Cash dividends
�
DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
How does the company’s earnings performance compare with that of previous years?
Net income available to common stockholders and average common shares outstanding
A higher measure suggests improved performance, although the number is subject to manipulation. Values should not be compared across companies.
INFO NEEDED FOR DECISION
DECISION TOOLKIT A SUMMARY
Earnings per share
Net income � Preferred stock dividends Average common shares outstanding
�
Glossary Accrual-basis accounting (p. 66) Transactions that change a company’s financial statements are recorded in the periods in which the events occur.
Classified balance sheet (p. 48) A balance sheet that contains a number of standard classifications and sections.
Comparability (p. 65) Ability to compare the account- ing information of different companies because they use the same accounting principles.
Consistency (p. 65) Use of the same accounting prin- ciples and methods from year to year within a company.
Cost constraint (p. 67) Constraint of determining whether the cost that companies will incur to provide the information will outweigh the benefit that financial state- ment users will gain from having the information available.
Cost principle (p. 67) An accounting principle that states that companies should record assets at their cost.
Current assets (p. 49) Cash and other resources that companies reasonably expect to convert to cash or use up within one year or the operating cycle, whichever is longer.
Current liabilities (p. 52) Obligations that a company reasonably expects to pay within the next year or oper- ating cycle, whichever is longer.
Current ratio (p. 59) A measure used to evaluate a company’s liquidity and short-term debt-paying ability; computed as current assets divided by current liabilities.
Debt to total assets ratio (p. 60) Measures the per- centage of total financing provided by creditors; com- puted as total debt divided by total assets.
Earnings per share (EPS) (p. 55) A measure of the net income earned on each share of common stock; com- puted as net income minus preferred stock dividends di- vided by the average number of common shares out- standing during the year.
Economic entity assumption (p. 66) An assumption that every economic entity can be separately identified and accounted for.
Fair value principle (p. 67) Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).
Faithful representation (p. 65) Information that is complete, neutral, and free from error.
Financial Accounting Standards Board (FASB) (p. 64) The primary accounting standard-setting body in the United States.
Free cash flow (p. 61) Cash remaining from operating activities after adjusting for capital expenditures and div- idends paid.
Full disclosure principle (p. 67) Accounting principle that dictates that companies disclose circumstances and events that make a difference to financial statement users.
Generally accepted accounting principles (GAAP) (p. 63) A set of rules and practices, having substantial authoritative support, that the accounting profession recognizes as a gen- eral guide for financial reporting purposes.
Going concern assumption (p. 66) The assumption that the company will continue in operation for the fore- seeable future.
Intangible assets (p. 51) Assets that do not have phys- ical substance.
International Accounting Standards Board (IASB) (p. 64) An accounting standard-setting body that issues standards adopted by many countries outside of the United States.
International Financial Reporting Standards (IFRS) (p. 64) Accounting standards, issued by the IASB, that have been adopted by many countries outside of the United States.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 71
72 chapter 2 A Further Look at Financial Statements
Liquidity (p. 58) The ability of a company to pay obli- gations that are expected to become due within the next year or operating cycle.
Liquidity ratios (p. 59) Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Long-term investments (p. 50) Generally, (1) invest- ments in stocks and bonds of other corporations that companies hold for more than one year, and (2) long- term assets, such as land and buildings, not currently be- ing used in the company’s operations.
Long-term liabilities (Long-term debt) (p. 52) Oblig- ations that a company expects to pay after one year.
Materiality constraint (p. 67) The constraint of deter- mining whether an item is large enough to likely influ- ence the decision of an investor or creditor.
Monetary unit assumption (p. 66) An assumption that requires that only those things that can be expressed in money are included in the accounting records.
Operating cycle (p. 50) The average time required to go from cash to cash in producing revenue.
Periodicity assumption (p. 66) An assumption that the life of a business can be divided into artificial time peri- ods and that useful reports covering those periods can be prepared for the business.
Profitability ratios (p. 55) Measures of the operating success of a company for a given period of time.
Property, plant, and equipment (p. 51) Assets with relatively long useful lives that companies use in operat- ing the business.
Public Company Accounting Oversight Board (PCAOB) (p. 64) The group charged with determining
auditing standards and reviewing the performance of au- diting firms. Ratio (p. 54) An expression of the mathematical rela- tionship between one quantity and another. Ratio analysis (p. 54) A technique for evaluating finan- cial statements that expresses the relationship among selected items of financial statement data. Relevance (p. 65) The quality of information that in- dicates the information makes a difference in a decision. Securities and Exchange Commission (SEC) (p. 64) The agency of the U.S. government that oversees U.S. fi- nancial markets and accounting standard-setting bodies. Solvency (p. 60) The ability of a company to pay inter- est as it comes due and to repay the balance of debt at its maturity. Solvency ratios (p. 60) Measures of the ability of the company to survive over a long period of time. Statement of stockholders’ equity (p. 57) A financial statement that presents the factors that caused stock- holders’ equity to change during the period, including those that caused retained earnings to change. Timely (p. 65) Information that is available to decision makers before it loses its capacity to influence decisions. Understandability (p. 65) Information presented in a clear and concise fashion so that users can interpret it and comprehend its meaning. Verifiable (p. 65) Information that is proven to be free from error. Working capital (p. 59) The difference between the amounts of current assets and current liabilities.
Comprehensive
Listed here are items taken from the income statement and balance sheet of Bargain Electronics, Inc. for the year ended December 31, 2012. Certain items have been com- bined for simplification. Amounts are given in thousands.
Notes payable (due in 3 years) $ 50.5 Cash 141.1 Salaries and wages expense 2,933.6 Common stock 454.9 Accounts payable 922.2 Accounts receivable 723.3 Equipment, net 921.0 Cost of goods sold 9,501.4 Income taxes payable 7.2 Interest expense 1.5 Mortgage payable 451.5 Retained earnings 1,336.3 Inventory 1,636.5 Sales revenue 12,456.9 Short-term investments 382.6 Income tax expense 30.5 Goodwill 202.7 Notes payable (due in 6 months) 784.6
Do it!
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 72
Comprehensive Do it! 73
Solution to Comprehensive Do it!
BARGAIN ELECTRONICS, INC. Income Statement
For the Year Ended December 31, 2012 (in thousands)
Sales revenue $12,456.9 Cost of goods sold $9,501.4 Salaries and wages expense 2,933.6 Interest expense 1.5 Income tax expense 30.5
Total expenses 12,467.0
Net loss $(10.1)
BARGAIN ELECTRONICS, INC. Balance Sheet
December 31, 2012 (in thousands)
Assets
Current assets Cash $ 141.1 Short-term investments 382.6 Accounts receivable 723.3 Inventory 1,636.5
Total current assets $2,883.5
Equipment, net 921.0 Goodwill 202.7
Total assets $4,007.2
Liabilities and Stockholders’ Equity
Current liabilities Notes payable $ 784.6 Accounts payable 922.2 Income taxes payable 7.2
Total current liabilities $1,714.0
Long-term liabilities Mortgage payable 451.5 Notes payable 50.5 502.0
Total liabilities 2,216.0
Stockholders’ equity Common stock 454.9 Retained earnings 1,336.3
Total stockholders’ equity 1,791.2
Total liabilities and stockholders’ equity $4,007.2
Action Plan
• In preparing the income statement, list revenues, then expenses.
• In preparing a classified balance sheet, list current assets in order of liquidity.
Instructions
Prepare an income statement and a classified balance sheet using the items listed. Do not use any item more than once.
c02AFurtherLookatFinancialStatements.qxd 10/12/10 11:31 AM Page 73
74 chapter 2 A Further Look at Financial Statements
Self-Test Questions Answers are on page 96.
1. In a classified balance sheet, assets are usually clas- sified 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.
2. Current assets are listed: (a) by order of expected conversion to cash. (b) by importance. (c) by longevity. (d) alphabetically.
3. The correct order of presentation in a classified bal- ance 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.
4. A company has purchased a tract of land. It expects to build a production plant on the land in approxi- mately 5 years. During the 5 years before construc- tion, the land will be idle. The land should be re- ported as: (a) property, plant, and equipment. (b) land expense. (c) a long-term investment. (d) an intangible asset.
5. Which is an indicator of profitability? (a) Current ratio. (b) Earnings per share. (c) Debt to total assets ratio. (d) Free cash flow.
6. For 2012, Ganos Corporation reported net income $26,000; net sales $400,000; and average shares outstanding 4,000. There were preferred stock dividends of $2,000. What was the 2012 earn- ings per share? (a) $6.00 (c) $99.50 (b) $6.50 (d) $100.00
7. The balance in retained earnings is not affected by: (a) net income. (b) net loss.
(c) issuance of common stock. (d) dividends.
8. 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.
9. The following ratios are available for Bachus Inc. and Newton Inc.
Current Debt to Earnings Ratio Assets Ratio 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 prof-
itability cannot be compared based on informa- tion provided.
10. 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.
11. 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.
12. 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.
13. What is the primary criterion by which accounting information can be judged? (a) Consistency. (b) Predictive value. (c) Usefulness for decision making. (d) Comparability.
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more resources are available for practice in WileyPLUS
(SO 1)
(SO 1)
(SO 1)
(SO 1)
(SO 2)
(SO 2)
(SO 3)
(SO 4)
(SO 2, 4)
(SO 5)
(SO 6)
(SO 6)
(SO 7)
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 74
14. Neutrality is an ingredient of:
Faithful representation Relevance
(a) Yes Yes (b) No No (c) Yes No (d) No Yes
15. What accounting constraint allows a company to ignore GAAP if an item is too small to impact a decision? (a) Comparability. (c) Cost. (b) Materiality. (d) Consistency.
Go to the book’s companion website, www. wiley.com/college/kimmel, to access addi- tional Self-Test Questions.
Questions 75
(SO 7) (SO 7)
1. What is meant by the term operating cycle?
2. Define current assets. What basis is used for order- ing individual items within the current assets section?
3. Distinguish between long-term investments and property, plant, and equipment.
4. How do current liabilities differ from long-term liabilities?
5. Identify the two parts of stockholders’ equity in a corporation and indicate the purpose of each.
6. (a) Julia Alter believes that the analysis of financial
statements is directed at two characteristics of a company: liquidity and profitability. Is Julia cor- rect? Explain.
(b) Are short-term creditors, long-term creditors, and stockholders primarily interested in the same characteristics of a company? Explain.
7. Name ratios useful in assessing (a) liquid- ity, (b) solvency, and (c) profitability.
8. Jon Baird, the founder of Water- boots Inc., needs to raise $500,000 to expand his company’s operations. He has been told that raising the money through debt will increase the riskiness of his company much more than issuing stock. He doesn’t understand why this is true. Explain it to him.
9. What do these classes of ratios measure? (a) Liquidity ratios. (b) Profitability ratios. (c) Solvency ratios.
10. Holding all other factors constant, indicate whether each of the following signals gen- erally good or bad news about a company.
(a) Increase in earnings per share. (b) Increase in the current ratio. (c) Increase in the debt to total assets ratio. (d) Decrease in free cash flow.
11. Which ratio or ratios from this chapter do you think should be of greatest interest to: (a) a pension fund considering investing in a corpo-
ration’s 20-year bonds? (b) a bank contemplating a short-term loan? (c) an investor in common stock?
12. (a) What are generally accepted accounting princi- ples (GAAP)?
(b) What body provides authoritative support for GAAP?
13. (a) What is the primary objective of financial reporting?
(b) Identify the characteristics of useful accounting information.
14. Dan Fineman, the president of King Company, is pleased. King substantially increased its net income in 2012 while keeping its unit inventory relatively the same. Howard Gross, chief accountant, cautions Dan, however. Gross says that since King changed its method of inventory valuation, there is a consistency problem and it is difficult to determine whether King is better off. Is Gross correct? Why or why not?
15. What is the distinction between comparability and consistency?
16. Describe the two constraints inherent in the presen- tation of accounting information.
17. Your roommate believes that international account- ing standards are uniform throughout the world. Is your roommate correct? Explain.
18. Laurie Belk is president of Better Books. She has no accounting background. Belk cannot understand why fair value is not used as the basis for all ac- counting measurement and reporting. Discuss.
19. What is the economic entity assumption? Give an example of its violation.
20. What was Tootsie Roll’s largest current as- set, largest current liability, and largest item under “Other assets” at December 31, 2009?
Questions
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 75
76 chapter 2 A Further Look at Financial Statements
Brief Exercises BE2-1 The following are the major balance sheet classifications:
Current assets (CA) Current liabilities (CL) Long-term investments (LTI) Long-term liabilities (LTL) Property, plant, and equipment (PPE) Common stock (CS) Intangible assets (IA) Retained earnings (RE)
Match each of the following accounts to its proper balance sheet classification.
_____ Accounts payable _____ Income taxes payable _____ Accounts receivable _____ Investment in long-term bonds _____ Accumulated depreciation _____ Land _____ Buildings _____ Inventory _____ Cash _____ Patent _____ Goodwill _____ Supplies
BE2-2 A list of financial statement items for Georges Company includes the following: accounts receivable $14,000; prepaid insurance $2,600; cash $10,400; supplies $3,800, and short-term investments $8,200. Prepare the current assets section of the balance sheet listing the items in the proper sequence.
BE2-3 The following information (in millions of dollars) is available for Limited Brands for 2008: Sales revenue $9,043; net income $220; preferred stock dividend $0; average shares outstanding 333 million. Compute the earnings per share for Limited Brands for 2008.
BE2-4 For each of the following events affecting the stockholders’ equity of Willis, indi- cate whether the event would: increase retained earnings (IRE), decrease retained earn- ings (DRE), increase common stock (ICS), or decrease common stock (DCS).
_____ (a) Issued new shares of common stock. _____ (b) Paid a cash dividend. _____ (c) Reported net income of $75,000. _____ (d) Reported a net loss of $20,000.
BE2-5 These selected condensed data are taken from a recent balance sheet of Bob Evans Farms (in millions of dollars).
Cash $ 29.3 Accounts receivable 20.5 Inventory 28.7 Other current assets 24.0
Total current assets $102.5 Total current liabilities $201.2
Compute working capital and the current ratio.
BE2-6 Kalb’s Books & Music Inc. reported the following selected information at March 31.
2012
Total current assets $262,787 Total assets 439,832 Total current liabilities 293,625 Total liabilities 376,002 Cash provided by operating activities 62,300
Calculate (a) the current ratio, (b) the debt to total assets ratio, and (c) free cash flow for March 31, 2012. The company paid dividends of $12,000 and spent $24,787 on capital expenditures.
BE2-7 Indicate whether each statement is true or false. (a) GAAP is a set of rules and practices established by accounting standard-setting bod-
ies to serve as a general guide for financial reporting purposes. (b) Substantial authoritative support for GAAP usually comes from two standards-setting
bodies: the FASB and the IRS.
Classify accounts on balance sheet.
(SO 1), K
Prepare the current assets section of a balance sheet.
(SO 1), AP
Compute earnings per share.
(SO 2), AP
Identify items affecting stockholders’ equity.
(SO 3), K
Calculate liquidity ratios.
(SO 4), AP
Calculate liquidity and solvency ratios.
(SO 4, 5), AP
Recognize generally accepted accounting principles.
(SO 6), K
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 76
BE2-8 The accompanying chart shows the qualitative characteristics of useful account- ing information. Fill in the blanks.
Do it! Review 77
Identify characteristics of useful information.
(SO 7), K
Usefulness Enhancing Qualities
Fundamental Qualities
Relevance
(a)
(b)
Consistency
(e)
(f )
(g)
and
Understandability
Faithful Representation
(c)
Neutral
(d)
BE2-9 Given the characteristics of useful accounting information, complete each of the following statements. (a) For information to be _____, it should have predictive and confirmatory value. (b) _____ is the quality of information that gives assurance that it is free from error and
bias. (c) _____ means using the same accounting principles and methods from year to year
within a company.
BE2-10 Here are some qualitative characteristics of useful accounting information: 1. Predictive value 3. Verifiable 2. Neutral 4. Timely
Match each qualitative characteristic to one of the following statements. ——— (a) Accounting information should help provide accurate expectations about
future events. ——— (b) Accounting information cannot be selected, prepared, or presented to favor
one set of interested users over another. ——— (c) Accounting information must be proved to be free of error. ——— (d) Accounting information must be available to decision makers before it loses
its capacity to influence their decisions.
BE2-11 The full disclosure principle dictates that: (a) financial statements should disclose all assets at their cost. (b) financial statements should disclose only those events that can be measured in dollars. (c) financial statements should disclose all events and circumstances that would matter
to users of financial statements. (d) financial statements should not be relied on unless an auditor has expressed an
unqualified opinion on them.
Identify characteristics of useful information.
(SO 7), K
Identify characteristics of useful information.
(SO 7), K
Define full disclosure principle.
(SO 7), K
2-1 Heather Corporation has collected the following information related to its December 31, 2012, balance sheet.
Accounts receivable $22,000 Equipment $180,000 Accumulated depreciation—equipment 50,000 Inventory 58,000 Cash 13,000 Supplies 7,000
Prepare the assets section of Heather Corporation’s balance sheet.
Do it!
ReviewDo it! Prepare assets section of balance sheet.
(SO 1), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 77
78 chapter 2 A Further Look at Financial Statements
2-2 The following financial statement items were taken from the financial state- ments of Jing Corp.
____ Trademarks ____ Inventory ____ Current maturities of long-term debt ____ Accumulated depreciation ____ Interest revenue ____ Land improvements ____ Income taxes payable ____ Common stock ____ Long-term marketable debt securities ____ Advertising expense ____ Unearned consulting fees ____ Mortgage payable (due in 3 years)
Match each of the financial statement items to its proper balance sheet classification. (See E2-1, on page 79, for a list of the balance sheet classifications.) If the item would not appear on a balance sheet, use “NA.”
2-3 The following information is available for Gerard Corporation.
2012 2011
Current assets $ 54,000 $ 36,000 Total assets 240,000 205,000 Current liabilities 22,000 30,000 Total liabilities 72,000 100,000 Net income 80,000 40,000 Cash provided by operating activities 90,000 56,000 Preferred stock dividends 6,000 6,000 Common stock dividends 3,000 1,500 Expenditures on property, plant, and equipment 27,000 12,000
Shares outstanding at beginning of year 40,000 30,000 Shares outstanding at end of year 75,000 40,000
(a) Compute earnings per share for 2012 and 2011 for Gerard, and comment on the change. Gerard’s primary competitor, Thorpe Corporation, had earnings per share of $1 per share in 2012. Comment on the difference in the ratios of the two companies.
(b) Compute the current ratio and debt to total assets ratio for each year, and comment on the changes.
(c) Compute free cash flow for each year, and comment on the changes.
2-4 The following are characteristics, assumptions, principles, or constraints that guide the FASB when it creates accounting standards.
Relevance Periodicity assumption Faithful representation Going concern assumption Comparability Cost principle Consistency Full disclosure principle Monetary unit assumption Materiality constraint Economic entity assumption Cost constraint
Match each item above with a description below.
1. __________ Items not easily quantified in dollar terms are not reported in the finan- cial statements.
2. __________ Accounting information must be complete, neutral, and free from error. 3. __________ Personal transactions are not mixed with the company’s transactions. 4. __________ The cost to provide information should be weighed against the benefit
that users will gain from having the information available. 5. __________ A company’s use of the same accounting principles from year to year. 6. __________ Assets are recorded and reported at original purchase price. 7. __________ Accounting information should help users predict future events, and
should confirm or correct prior expectations. 8. __________ The life of a business can be divided into artificial segments of time. 9. __________ The reporting of all information that would make a difference to financial
statement users. 10. __________ The judgment concerning whether an item’s size makes it likely to influ-
ence a decision maker. 11. __________ Assumes a business will remain in operation for the foreseeable future. 12. __________ Different companies use the same accounting principles.
Do it!
Do it!
Do it!
Classify financial statement items by balance sheet classification.
(SO 1), AP
Compute ratios and analyze.
(SO 4, 5), K
Identify financial accounting concepts and principles.
(SO 7), K
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 78
Exercises E2-1 The following are the major balance sheet classifications.
Current assets (CA) Current liabilities (CL) Long-term investments (LTI) Long-term liabilities (LTL) Property, plant, and equipment (PPE) Stockholders’ equity (SE) Intangible assets (IA)
Instructions Classify each of the following financial statement items taken from Inshore Corporation’s balance sheet.
____ Accounts payable ____ Income taxes payable ____ Accounts receivable ____ Inventory ____ Accumulated depreciation— ____ Investments
equipment ____ Land ____ Buildings ____ Mortgage payable ____ Cash ____ Supplies ____ Interest payable ____ Equipment ____ Goodwill ____ Prepaid rent
E2-2 The major balance sheet classifications are listed in E2-1 above.
Instructions Classify each of the following financial statement items based upon the major balance sheet classifications listed in E2-1.
____ Prepaid advertising ____ Patents ____ Equipment ____ Bonds payable ____ Trademarks ____ Common stock ____ Salaries and wages payable ____ Accumulated depreciation— ____ Income taxes payable equipment ____ Retained earnings ____ Unearned sales revenue ____ Accounts receivable ____ Inventory ____ Land held for future use
E2-3 The following items were taken from the December 31, 2009, assets section of the Boeing Company balance sheet. (All dollars are in millions.)
Inventories $16,933 Other current assets $ 966 Notes receivable—due after Property, plant, and
December 31, 2010 5,466 equipment 21,579 Notes receivable—due before Cash and cash equivalents 9,215
December 31, 2010 368 Accounts receivable 5,785 Accumulated depreciation 12,795 Short-term investments 2,008 Intangible and other assets 12,528
Instructions Prepare the assets section of a classified balance sheet, listing the current assets in order of their liquidity.
E2-4 The following information (in thousands of dollars) is available for H.J. Heinz Company—famous for ketchup and other fine food products—for the year ended April 29, 2009.
Prepaid expenses $ 125,765 Inventories $1,237,613 Land 76,193 Buildings and equipment 4,033,369 Other current assets 36,701 Cash and cash equivalents 373,145 Intangible assets 3,982,954 Accounts receivable 1,171,797 Other noncurrent assets 757,907 Accumulated depreciation 2,131,260
Instructions Prepare the assets section of a classified balance sheet, listing the items in proper se- quence and including a statement heading.
Exercises 79
Classify accounts on balance sheet.
(SO 1), AP
Classify financial statement items by balance sheet classification.
(SO 1), AP
Classify items as current or noncurrent, and prepare assets section of balance sheet.
(SO 1), AP
Prepare assets section of a classified balance sheet.
(SO 1), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 79
80 chapter 2 A Further Look at Financial Statements
E2-5 These items are taken from the financial statements of Victory Co. at December 31, 2012.
Buildings $105,800 Accounts receivable 12,600 Prepaid insurance 3,200 Cash 11,840 Equipment 82,400 Land 61,200 Insurance expense 780 Depreciation expense 5,300 Interest expense 2,600 Common stock 60,000 Retained earnings (January 1, 2012) 40,000 Accumulated depreciation—buildings 45,600 Accounts payable 9,500 Notes payable 93,600 Accumulated depreciation—equipment 18,720 Interest payable 3,600 Service revenue 14,700
Instructions Prepare a classified balance sheet. Assume that $13,600 of the note payable will be paid in 2013.
E2-6 The following items were taken from the 2009 financial statements of Texas Instruments, Inc. (All dollars are in millions.)
Common stock $2,826 Cash and cash equivalents $1,182 Prepaid expenses 164 Accumulated depreciation 3,547 Property, plant, and equipment 6,705 Accounts payable 1,344 Other current assets 546 Other noncurrent assets 2,210 Other current liabilities 115 Noncurrent liabilities 810 Long-term investments 637 Retained earnings 6,896 Short-term investments 1,743 Accounts receivable 1,277 Income taxes payable 128 Inventories 1,202
Instructions Prepare a classified balance sheet in good form as of December 31, 2009.
E2-7 The following information is available for Callaway Golf Company for the years 2008 and 2007. (Dollars are in thousands, except share information.)
2008 2007
Net sales $ 1,117,204 $ 1,124,591 Net income (loss) 66,176 54,587 Total assets 855,338 838,078
Share information
Shares outstanding at year-end 64,507,000 66,282,000 Preferred dividends –0– –0–
There were 73,139,000 shares outstanding at the end of 2006.
Instructions (a) What was the company’s earnings per share for each year? (b) Based on your findings above, how did the company’s profitability change from 2007
to 2008? (c) Suppose the company had paid dividends on preferred stock and on common stock
during the year. How would this affect your calculation in part (a)?
E2-8 These financial statement items are for Whitnall Corporation at year-end, July 31, 2012.
Salaries and wages payable $ 2,080 Salaries and wages expense 57,500 Supplies expense 15,600
Prepare a classified balance sheet.
(SO 1), AP
Prepare a classified balance sheet.
(SO 1), AP
Compute and interpret profitability ratio.
(SO 2), AP
Prepare financial statements.
(SO 1, 3, 4), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 80
Equipment $18,500 Accounts payable 4,100 Service revenue 66,100 Rent revenue 8,500 Notes payable (due in 2015) 1,800 Common stock 16,000 Cash 29,200 Accounts receivable 9,780 Accumulated depreciation—equipment 6,000 Dividends 4,000 Depreciation expense 4,000 Retained earnings (beginning of the year) 34,000
Instructions (a) Prepare an income statement and a retained earnings statement for the year. Whitnall
Corporation did not issue any new stock during the year. (b) Prepare a classified balance sheet at July 31. (c) Compute the current ratio and debt to total assets ratio. (d) Suppose that you are the president of Crescent Equipment. Your sales manager has
approached you with a proposal to sell $20,000 of equipment to Whitnall. He would like to provide a loan to Whitnall in the form of a 10%, 5-year note payable. Evaluate how this loan would change Whitnall’s current ratio and debt to total assets ratio, and discuss whether you would make the sale.
E2-9 Nordstrom, Inc. operates department stores in numerous states. Selected finan- cial statement data (in millions of dollars) for the year ended January 31, 2009, follow.
End of Year Beginning of Year
Cash and cash equivalents $ 72 $ 358 Receivables (net) 1,942 1,788 Merchandise inventory 900 956 Other current assets 303 259
Total current assets $3,217 $3,361 Total current liabilities $1,601 $1,635
Instructions (a) Compute working capital and the current ratio at the beginning of the year and at the
end of the current year. (b) Did Nordstrom’s liquidity improve or worsen during the year? (c) Using the data in the chapter, compare Nordstrom’s liquidity with Best Buy’s.
E2-10 The chief financial officer (CFO) of Padilla Corporation requested that the ac- counting department prepare a preliminary balance sheet on December 30, 2012, so that the CFO could get an idea of how the company stood. He knows that certain debt agree- ments with its creditors require the company to maintain a current ratio of at least 2:1. The preliminary balance sheet is as follows.
Exercises 81
PADILLA CORP. Balance Sheet
December 30, 2012
Current assets Current liabilities Cash $25,000 Accounts payable $ 20,000 Accounts receivable 30,000 Salaries and wages payable 10,000 $ 30,000
Prepaid insurance 5,000 $ 60,000 Long-term liabilities
Equipment (net) 200,000 Notes payable 80,000
Total assets $260,000 Total liabilities 110,000 Stockholders’ equity
Common stock 100,000 Retained earnings 50,000 150,000
Total liabilities and stockholders’ equity $260,000
Compute liquidity ratios and compare results.
(SO 4), AP
Compute liquidity measures and discuss findings.
(SO 4), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 81
82 chapter 2 A Further Look at Financial Statements
Instructions (a) Calculate the current ratio and working capital based on the preliminary balance
sheet. (b) Based on the results in (a), the CFO requested that $20,000 of cash be used to pay off
the balance of the accounts payable account on December 31, 2012. Calculate the new current ratio and working capital after the company takes these actions.
(c) Discuss the pros and cons of the current ratio and working capital as measures of liq- uidity.
(d) Was it unethical for the CFO to take these steps?
E2-11 The following data were taken from the 2009 and 2008 financial statements of American Eagle Outfitters. (All dollars are in thousands.)
2009 2008
Current assets $ 925,359 $1,020,834 Total assets 1,963,676 1,867,680 Current liabilities 401,763 376,178 Total liabilities 554,645 527,216 Total stockholders’ equity 1,409,031 1,340,464 Cash provided by operating activities 302,193 464,270 Capital expenditures 265,335 250,407 Dividends paid 82,394 80,796
Instructions Perform each of the following. (a) Calculate the debt to total assets ratio for each year. (b) Calculate the free cash flow for each year. (c) Discuss American Eagle’s solvency in 2009 versus 2008. (d) Discuss American Eagle’s ability to finance its investment activities with cash provided
by operating activities, and how any deficiency would be met.
E2-12 Presented below are the assumptions and principles discussed in this chapter.
1. Full disclosure principle. 4. Periodicity assumption.
2. Going concern assumption. 5. Cost principle.
3. Monetary unit assumption. 6. Economic entity assumption.
Instructions Identify by number the accounting assumption or principle that is described below. Do not use a number more than once.
——— (a) Is the rationale for why plant assets are not reported at liquidation value. (Note: Do not use the cost principle.)
——— (b) Indicates that personal and business record-keeping should be separately maintained.
——— (c) Assumes that the dollar is the “measuring stick” used to report on financial performance.
——— (d) Separates financial information into time periods for reporting purposes. ——— (e) Measurement basis used when a reliable estimate of fair value is not available. ——— (f ) Dictates that companies should disclose all circumstances and events that
make a difference to financial statement users.
E2-13 Rosman Co. had three major business transactions during 2012.
(a) Reported at its fair value of $260,000 merchandise inventory with a cost of $208,000. (b) The president of Rosman Co., Jay Rosman, purchased a truck for personal use and
charged it to his expense account. (c) Rosman Co. wanted to make its 2012 income look better, so it added 2 more weeks to
the year (a 54-week year). Previous years were 52 weeks.
Instructions In each situation, identify the assumption or principle that has been violated, if any, and discuss what the company should have done.
Compute and interpret solvency ratios.
(SO 4, 5), AP
Identify accounting assumptions and principles.
(SO 7), K
Identify the assumption or principle that has been violated.
(SO 7), C
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 82
Problems: Set A P2-1A The following items are taken from the 2008 balance sheet of Yahoo! Inc. (All dollars are in thousands.)
Intangible assets $3,926,749 Common stock 6,282,504 Property and equipment, net 1,536,181 Accounts payable 151,897 Other assets 233,989 Long-term investments 3,247,431 Accounts receivable 1,060,450 Prepaid expenses and other current assets 233,061 Short-term investments 1,159,691 Retained earnings 4,968,438 Cash and cash equivalents 2,292,296 Long-term debt 733,891 Accrued expenses and other current liabilities 1,139,894 Unearned revenue—current 413,224
Instructions Prepare a classified balance sheet for Yahoo! Inc. as of December 31, 2008.
P2-2A These items are taken from the financial statements of Xenox Corporation for 2012.
Retained earnings (beginning of year) $31,000 Utilities expense 2,000 Equipment 66,000 Accounts payable 18,300 Cash 10,100 Salaries and wages payable 3,000 Common stock 12,000 Dividends 12,000 Service revenue 68,000 Prepaid insurance 3,500 Maintenance and repairs expense 1,800 Depreciation expense 3,600 Accounts receivable 11,700 Insurance expense 2,200 Salaries and wages expense 37,000 Accumulated depreciation—equipment 17,600
Instructions Prepare an income statement, a retained earnings statement, and a classified balance sheet as of December 31, 2012.
P2-3A You are provided with the following information for Merrell Enterprises, effec- tive as of its April 30, 2012, year-end.
Accounts payable $ 834 Accounts receivable 810 Accumulated depreciation—equipment 670 Cash 1,270 Common stock 900 Cost of goods sold 1,060
Problems: Set A 83
Exercises: Set B and Challenge Exercises Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercise Set B and Challenge Exercises.
Prepare a classified balance sheet.
(SO 1), AP
Tot. current assets $4,745,498 Tot. assets $13,689,848
Prepare financial statements.
(SO 1, 3), AP
Net income $21,400 Tot. assets $73,700
Prepare financial statements.
(SO 1, 3), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 83
84 chapter 2 A Further Look at Financial Statements
Depreciation expense $ 335 Dividends 325 Equipment 2,420 Income tax expense 165 Income taxes payable 135 Insurance expense 210 Interest expense 400 Inventory 967 Land 3,100 Mortgage payable 3,500 Notes payable 61 Prepaid insurance 60 Retained earnings (beginning) 1,600 Sales revenue 5,100 Short-term investments 1,200 Salaries and wages expense 700 Salaries and wages payable 222
Instructions (a) Prepare an income statement and a retained earnings statement for Merrell
Enterprises for the year ended April 30, 2012. (b) Prepare a classified balance sheet for Merrell Enterprises as of April 30, 2012.
P2-4A Comparative financial statement data for Duran Corporation and Kiepert Cor- poration, two competitors, appear below. All balance sheet data are as of December 31, 2012.
Duran Corporation Kiepert Corporation
2012 2012
Net sales $1,800,000 $620,000 Cost of goods sold 1,175,000 340,000 Operating expenses 283,000 98,000 Interest expense 9,000 3,800 Income tax expense 85,000 36,000 Current assets 407,200 190,336 Plant assets (net) 532,000 139,728 Current liabilities 66,325 33,716 Long-term liabilities 108,500 40,684 Cash from operating activities 138,000 36,000 Capital expenditures 90,000 20,000 Dividends paid on common stock 36,000 15,000
Average number of shares outstanding 80,000 50,000
Instructions (a) Comment on the relative profitability of the companies by computing the net income
and earnings per share for each company for 2012. (b) Comment on the relative liquidity of the companies by computing working capital
and the current ratios for each company for 2012. (c) Comment on the relative solvency of the companies by computing the debt to total
assets ratio and the free cash flow for each company for 2012.
P2-5A Here and on page 85 are financial statements of Batcha Company.
BATCHA COMPANY Income Statement
For the Year Ended December 31, 2012
Net sales $2,218,500 Cost of goods sold 1,012,400 Selling and administrative expenses 906,000 Interest expense 78,000 Income tax expense 69,000
Net income $ 153,100
Net income $2,230 Tot. current assets $4,307 Tot. assets $9,157
Compute ratios; comment on relative profitability, liquidity, and solvency.
(SO 2, 4, 5), AN
Compute and interpret liquidity, solvency, and profitability ratios.
(SO 2, 4, 5), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 84
BATCHA COMPANY Balance Sheet
December 31, 2012
Assets
Current assets Cash $ 60,100 Short-term investments 84,000 Accounts receivable (net) 169,800 Inventory 145,000
Total current assets 458,900
Plant assets (net) 575,300
Total assets $1,034,200
Liabilities and Stockholders’ Equity
Current liabilities Accounts payable $ 160,000 Income taxes payable 35,500
Total current liabilities 195,500
Bonds payable 200,000
Total liabilities 395,500
Stockholders’ equity Common stock 350,000 Retained earnings 288,700
Total stockholders’ equity 638,700
Total liabilities and stockholders’ equity $1,034,200
Additional information: The cash provided by operating activities for 2012 was $190,800. The cash used for capital expenditures was $92,000. The cash used for dividends was $31,000. The average number of shares outstanding during the year was 50,000.
Instructions (a) Compute the following values and ratios for 2012. (We provide the results from 2011
for comparative purposes.) (i) Working capital. (2011: $160,500)
(ii) Current ratio. (2011: 1.65:1) (iii) Free cash flow. (2011: $48,700) (iv) Debt to total assets ratio. (2011: 31%) (v) Earnings per share. (2011: $3.15)
(b) Using your calculations from part (a), discuss changes from 2011 in liquidity, solvency, and profitability.
P2-6A Condensed balance sheet and income statement data for Sievert Corporation are presented here and on the next page.
SIEVERT CORPORATION Balance Sheets December 31
Assets 2012 2011
Cash $ 28,000 $ 20,000 Receivables (net) 70,000 62,000 Other current assets 90,000 73,000 Long-term investments 62,000 60,000 Plant and equipment (net) 510,000 470,000
Total assets $760,000 $685,000
Liabilities and Stockholders’ Equity
Current liabilities $ 75,000 $ 70,000 Long-term debt 80,000 90,000 Common stock 330,000 300,000 Retained earnings 275,000 225,000
Total liabilities and stockholders’ equity $760,000 $685,000
Problems: Set A 85
Compute and interpret liquidity, solvency, and profitability ratios.
(SO 2, 4, 5), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 85
86 chapter 2 A Further Look at Financial Statements
SIEVERT CORPORATION Income Statements
For the Years Ended December 31
2012 2011
Sales $750,000 $680,000 Cost of goods sold 440,000 400,000 Operating expenses (including income taxes) 240,000 220,000
Net income $ 70,000 $ 60,000
Additional information:
Cash from operating activities $82,000 $56,000 Cash used for capital expenditures $45,000 $38,000 Dividends paid $20,000 $15,000 Average number of shares outstanding 33,000 30,000
Instructions Compute these values and ratios for 2011 and 2012. (a) Earnings per share. (b) Working capital. (c) Current ratio. (d) Debt to total assets ratio. (e) Free cash flow. (f ) Based on the ratios calculated, discuss briefly the improvement or lack thereof in
financial position and operating results from 2011 to 2012 of Sievert Corporation.
P2-7A Selected financial data of two competitors, Target and Wal-Mart, are presented here. (All dollars are in millions.)
Target Wal-Mart (1/31/09) (1/31/09)
Income Statement Data for Year
Net sales $64,948 $401,244 Cost of goods sold 44,157 306,158 Selling and administrative expenses 16,389 76,651 Interest expense 894 2,103 Other income 28 4,213 Income taxes 1,322 7,145
Net income $ 2,214 $ 13,400
Target Wal-Mart
Balance Sheet Data (End of Year)
Current assets $17,488 $ 48,949 Noncurrent assets 26,618 114,480
Total assets $44,106 $163,429
Current liabilities $10,512 $ 55,390 Long-term debt 19,882 42,754 Total stockholders’ equity 13,712 65,285
Total liabilities and stockholders’ equity $44,106 $163,429
Cash from operating activities $4,430 $23,147 Cash paid for capital expenditures 3,547 11,499 Dividends declared and paid on common stock 465 3,746
Average shares outstanding (millions) 774 3,951
Instructions
For each company, compute these values and ratios. (a) Working capital. (b) Current ratio.
Compute ratios and compare liquidity, solvency, and profitability for two companies.
(SO 2, 4, 5), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 86
(c) Debt to total assets ratio. (d) Free cash flow. (e) Earnings per share. (f ) Compare the liquidity and solvency of the two companies.
P2-8A A friend of yours, Ana Gehrig, recently completed an undergraduate degree in science and has just started working with a biotechnology company. Ana tells you that the owners of the business are trying to secure new sources of financing which are needed in order for the company to proceed with development of a new health care product. Ana said that her boss told her that the company must put together a report to present to po- tential investors.
Ana thought that the company should include in this package the detailed scientific findings related to the Phase I clinical trials for this product. She said, “I know that the biotech industry sometimes has only a 10% success rate with new products, but if we re- port all the scientific findings, everyone will see what a sure success this is going to be! The president was talking about the importance of following some set of accounting prin- ciples. Why do we need to look at some accounting rules? What they need to realize is that we have scientific results that are quite encouraging, some of the most talented em- ployees around, and the start of some really great customer relationships. We haven’t made any sales yet, but we will. We just need the funds to get through all the clinical testing and get government approval for our product. Then these investors will be quite happy that they bought in to our company early!”
Instructions (a) What is accounting information? Explain to Ana what is meant by generally accept-
ed accounting principles. (b) Comment on how Ana’s suggestions for what should be reported to prospective
investors conforms to the qualitative characteristics of accounting information. Do you think that the things that Ana wants to include in the information for investors will conform to financial reporting guidelines?
Problems: Set B 87
Comment on the objectives and qualitative characteris- tics of financial reporting.
(SO 6, 7), E
Problems: Set B P2-1B The following items are from the 2009 balance sheet of Kellogg Company. (All dollars are in millions.)
Common stock $ 577 Other assets 5,632 Notes payable—current 44 Other current assets 221 Cash and cash equivalents 334 Other long-term liabilities 1,802 Retained earnings 1,698 Accounts payable 1,077 Other current liabilities 1,167 Accounts receivable, net 1,093 Property, net 3,010 Inventories 910 Long-term debt 4,835
Instructions Prepare a classified balance sheet for Kellogg Company as of December 31, 2009.
P2-2B These items are taken from the financial statements of Tilley, Inc.
Prepaid insurance $ 1,400 Equipment 31,000 Salaries and wages expense 36,000 Utilities expense 2,100 Accumulated depreciation—equipment 8,600 Accounts payable 8,200 Cash 5,100
Prepare a classified balance sheet.
(SO 1), AP
Tot. current assets $2,558 Tot. assets $11,200
Prepare financial statements.
(SO 1, 3), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 87
88 chapter 2 A Further Look at Financial Statements
Accounts receivable $ 4,900 Salaries and wages payable 2,000 Common stock 6,000 Depreciation expense 4,300 Retained earnings (beginning) 14,000 Dividends 2,600 Service revenue 53,000 Maintenance and repairs expense 2,600 Insurance expense 1,800
Instructions Prepare an income statement, a retained earnings statement, and a classified balance sheet as of December 31, 2012.
P2-3B You are provided with the following information for Rapp Corporation, effective as of its April 30, 2012, year-end.
Accounts payable $ 2,100 Accounts receivable 9,150 Accumulated depreciation—equipment 6,600 Depreciation expense 2,200 Cash 21,955 Common stock 20,000 Dividends 2,800 Equipment 24,250 Sales revenue 21,450 Income tax expense 1,600 Income taxes payable 300 Interest expense 350 Interest payable 175 Notes payable (due in 2016) 5,700 Prepaid rent 380 Rent expense 760 Retained earnings, beginning 13,960 Salaries and wages expense 6,840
Instructions (a) Prepare an income statement and a retained earnings statement for Rapp
Corporation for the year ended April 30, 2012. (b) Prepare a classified balance sheet for Rapp as of April 30, 2012. (c) Explain how each financial statement interrelates with the others.
P2-4B Comparative statement data for Al Sharif Company and Weber Company, two competitors, are presented below. All balance sheet data are as of December 31, 2012.
Al Sharif Company Weber Company
2012 2012
Net sales $450,000 $890,000 Cost of goods sold 260,000 620,000 Operating expenses 130,000 59,000 Interest expense 6,000 10,000 Income tax expense 10,000 65,000 Current assets 180,000 700,000 Plant assets (net) 600,000 800,000 Current liabilities 75,000 300,000 Long-term liabilities 190,000 200,000 Cash from operating activities 46,000 180,000 Capital expenditures 20,000 50,000 Dividends paid 4,000 15,000
Average number of shares outstanding 200,000 400,000
Instructions (a) Compute the net income and earnings per share for each company for 2012.
Net income $6,200 Tot. assets $33,800
Prepare financial statements.
(SO 1, 3), AP
Net income $9,700 Tot. current assets $31,485 Tot. assets $49,135
Compute ratios; comment on relative profitability, liquidity, and solvency.
(SO 2, 4, 5), AN
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 88
(b) Comment on the relative liquidity of the companies by computing working capital and the current ratio for each company for 2012.
(c) Comment on the relative solvency of the companies by computing the debt to total assets ratio and the free cash flow for each company for 2012.
P2-5B The financial statements of DeVoe Company are presented here.
Problems: Set B 89
DEVOE COMPANY Income Statement
For the Year Ended December 31, 2012
Net sales $700,000 Cost of goods sold 400,000 Selling and administrative expenses 150,000 Interest expense 7,800 Income tax expense 43,000
Net income $ 99,200
DEVOE COMPANY Balance Sheet
December 31, 2012
Assets
Current assets Cash $ 18,100 Short-term investments 34,800 Accounts receivable (net) 90,700 Inventory 155,000
Total current assets 298,600
Plant assets (net) 465,300
Total assets $763,900
Liabilities and Stockholders’ Equity
Current liabilities Accounts payable $119,700 Income taxes payable 29,000
Total current liabilities 148,700
Bonds payable 110,000
Total liabilities 258,700
Stockholders’ equity Common stock 170,000 Retained earnings 335,200
Total stockholders’ equity 505,200
Total liabilities and stockholders’ equity $763,900
Cash from operating activities $ 71,300 Capital expenditures $ 42,000 Dividends paid $ 10,000 Average number of shares outstanding 65,000
Instructions (a) Compute the following values and ratios for 2012. (We provide the results from 2011
for comparative purposes.) (i) Current ratio. (2011: 2.4:1)
(ii) Working capital. (2011: $178,000) (iii) Debt to total assets ratio. (2011: 31%) (iv) Free cash flow. (2011: $13,000) (v) Earnings per share. (2011: $1.35)
(b) Using your calculations from part (a), discuss changes from 2011 in liquidity, solvency, and profitability.
Compute and interpret liquidity, solvency, and profitability ratios.
(SO 2, 4, 5), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 89
90 chapter 2 A Further Look at Financial Statements
P2-6B Condensed balance sheet and income statement data for Fellenz Corporation are presented below.
FELLENZ CORPORATION Balance Sheets December 31
Assets 2012 2011
Cash $ 40,000 $ 24,000 Receivables (net) 90,000 55,000 Other current assets 74,000 73,000 Long-term investments 78,000 60,000 Plant and equipment (net) 520,000 407,000
Total assets $802,000 $619,000
Liabilities and Stockholders’ Equity 2012 2011
Current liabilities $ 88,000 $ 65,000 Long-term debt 90,000 70,000 Common stock 370,000 320,000 Retained earnings 254,000 164,000
Total liabilities and stockholders’ equity $802,000 $619,000
FELLENZ CORPORATION Income Statements
For the Years Ended December 31
2012 2011
Sales $770,000 $800,000 Cost of goods sold 420,000 400,000 Operating expenses (including income taxes) 200,000 237,000
Net income $150,000 $163,000
Cash from operating activities $165,000 $178,000 Cash used for capital expenditures 85,000 45,000 Dividends paid 50,000 43,000
Average number of shares outstanding 370,000 320,000
Instructions Compute the following values and ratios for 2011 and 2012. (a) Earnings per share. (b) Working capital. (c) Current ratio. (d) Debt to total assets ratio. (e) Free cash flow. (f ) Based on the ratios calculated, discuss briefly the improvement or lack thereof in the
financial position and operating results of Fellenz from 2011 to 2012.
P2-7B Selected financial data of two competitors, Blockbuster Inc. and Movie Gallery, Inc., in a recent year are presented below and on page 91. (All dollars are in millions.)
Blockbuster Inc. Movie Gallery, Inc.
Income Statement Data for Year
Net sales $ 5,524 $2,542 Cost of goods sold 2,476 1,012 Selling and administrative expenses 2,755 1,431 Interest expense 102 120 Other expense 212 3 Income tax expense (refund) (76) 2
Net income (loss) $ 55 $ (26)
Compute and interpret liquidity, solvency, and profitability ratios.
(SO 2, 4, 5), AP
Compute ratios and compare liquidity, solvency, and profit- ability for two companies.
(SO 2, 4, 5), AP
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 90
Instructions For each company, compute these values and ratios. (a) Working capital. (b) Current ratio. (Round to two decimal places.) (c) Debt to total assets ratio. (d) Free cash flow. (e) Earnings per share. (f ) Compare the liquidity, profitability, and solvency of the two companies.
P2-8B Net Nanny Software International Inc., headquartered in Vancouver, specializes in Internet safety and computer security products for both the home and commercial markets. In a recent balance sheet, it reported a deficit (negative retained earnings) of US $5,678,288. It has reported only net losses since its inception. In spite of these losses, Net Nanny’s common shares have traded anywhere from a high of $3.70 to a low of $0.32 on the Canadian Venture Exchange.
Net Nanny’s financial statements have historically been prepared in Canadian dollars. Recently, the company adopted the U.S. dollar as its reporting currency.
Instructions (a) What is the objective of financial reporting? How does this objective meet or not meet
Net Nanny’s investors’ needs? (b) Why would investors want to buy Net Nanny’s shares if the company has consistently
reported losses over the last few years? Include in your answer an assessment of the relevance of the information reported on Net Nanny’s financial statements.
(c) Comment on how the change in reporting information from Canadian dollars to U.S. dollars likely affected the readers of Net Nanny’s financial statements. Include in your answer an assessment of the comparability of the information.
Continuing Cookie Chronicle 91
Blockbuster Inc. Movie Gallery, Inc.
Balance Sheet Data (End of Year)
Current assets $ 1,566 $ 239 Property, plant, and equipment (net) 580 243 Intangible assets 835 297 Other assets 156 374
Total assets $ 3,137 $1,153
Current liabilities $ 1,395 $ 268 Long-term debt 851 1,122 Total stockholders’ equity 891 (237)
Total liabilities and stockholders’ equity $ 3,137 $1,153
Cash from operating activities $329 $(10) Cash used for capital expenditures 79 20 Dividends paid 11 –0–
Average shares outstanding 189.0 31.8
Comment on the objectives and qualitative characteristics of accounting information.
(SO 6, 7), E
Problems: Set C Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problem Set C.
Continuing Cookie Chronicle (Note: This is a continuation of the Cookie Chronicle from Chapter 1.)
CCC2 After investigating the different forms of business organization, Natalie Koebel decides to operate her business as a corporation, Cookie Creations Inc., and she begins the process of getting her business running.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 91
92 chapter 2 A Further Look at Financial Statements
While at a trade show, Natalie is introduced to Gerry Richards, operations manager of “Biscuits,” a national food retailer. After much discussion, Gerry asks Natalie to con- sider being Biscuits’ major supplier of oatmeal chocolate chip cookies. He provides Natalie with the most recent copy of the financial statements of Biscuits. He expects that Natalie will need to supply Biscuits’ Watertown warehouse with approximately 1,500 dozen cookies a week. Natalie is to send Biscuits a monthly invoice, and she will be paid approximately 30 days from the date the invoice is received in Biscuits’ Chicago office.
Natalie is thrilled with the offer. However, she has recently read in the newspaper that Biscuits has a reputation for selling cookies and donuts with high amounts of sugar and fat, and as a result, consumer demand for the company’s products has decreased.
Instructions Natalie has several questions. Answer the following questions for Natalie. (a) What type of information does each financial statement provide? (b) What financial statements would Natalie need in order to evaluate whether Biscuits
will have enough cash to meet its current liabilities? Explain what to look for. (c) What financial statements would Natalie need in order to evaluate whether Biscuits
will be able to survive over a long period of time? Explain what to look for. (d) What financial statement would Natalie need in order to evaluate Biscuits’ profitabil-
ity? Explain what to look for. (e) Where can Natalie find out whether Biscuits has outstanding debt? How can Natalie
determine whether Biscuits would be able to meet its interest and debt payments on any debts it has?
(f ) How could Natalie determine whether Biscuits pays a dividend? (g) In deciding whether to go ahead with this opportunity, are there other areas of con-
cern that Natalie should be aware of?
Financial Reporting and Analysis FINANCIAL REPORTING PROBLEM: Tootsie Roll Industries Inc.
BYP2-1 The financial statements of Tootsie Roll Industries, Inc., appear in Appendix A at the end of this book.
Instructions Answer the following questions using the financial statements and the notes to the financial statements. (a) What were Tootsie Roll’s total current assets at December 31, 2009, and December 31, 2008? (b) Are the assets included in current assets listed in the proper order? Explain. (c) How are Tootsie Roll’s assets classified? (d) What were Tootsie Roll’s current liabilities at December 31, 2009, and December 31, 2008?
COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Hershey
BYP2-2 The financial statements of The Hershey Company appear in Appendix B, following the financial statements for Tootsie Roll in Appendix A. Assume Hershey’s average number of shares outstanding was 227,517,000, and Tootsie Roll’s was 56,072,000.
Instructions (a) For each company calculate the following values for 2009.
(1) Working capital. (4) Free cash flow. (2) Current ratio. (5) Earnings per share. (3) Debt to total assets ratio (Hint: When calculating free cash flow, do not consider business acquisitions to be part of capital expenditures.)
(b) Based on your findings above, discuss the relative liquidity and solvency of the two companies.
broadening your perspective
c02AFurtherLookatFinancialStatements.qxd 9/2/10 1:36 PM Page 92
RESEARCH CASE
BYP2-3 The April 27, 2009, edition of the Wall Street Journal Online includes an article by Cari Tuna entitled “Corporate Blogs and ‘Tweets’ Must Keep SEC in Mind.”
Instructions Read the article and answer the following questions. (a) At the time of the article, how many of the Fortune 500 companies sponsored public blogs?
Of these blogs, how many had links to corporate Twitter accounts? (b) What potential advantages might Twitter provide to companies in their efforts to communi-
cate with investors? (c) Why are some companies, such as Intel, wary of using Twitter and blogs to communicate to
investors? (d) What recommendations does Lisa Wood, of Foley Hoag LLP, make to companies if they use
blogs or Twitter to communicate to investors?
INTERPRETING FINANCIAL STATEMENTS
BYP2-4 The following information was reported by Gap, Inc. in its 2009 annual report.
2009 2008 2007 2006 2005
Total assets (millions) $7,985 $7,564 $7,838 $ 8,544 $ 8,821 Working capital 2,533 1,847 1,653 $ 2,757 $ 3,297 Current ratio 2.19:1 1.86:1 1.68:1 2.21:1 2.70:1 Debt to total assets ratio .39:1 .42:1 .45:1 .39:1 .38:1 Earnings per share $1.59 $1.35 $1.05 $0.94 $1.26
(a) Determine the overall percentage decrease in Gap’s total assets from 2005 to 2009. What was the average decrease per year?
(b) Comment on the change in Gap’s liquidity. Does working capital or the current ratio appear to provide a better indication of Gap’s liquidity? What might explain the change in Gap’s liq- uidity during this period?
(c) Comment on the change in Gap’s solvency during this period. (d) Comment on the change in Gap’s profitability during this period. How might this affect your
prediction about Gap’s future profitability?
FINANCIAL ANALYSIS ON THE WEB
BYP2-5 Purpose: Identify summary liquidity, solvency, and profitability information about com- panies, and compare this information across companies in the same industry.
Address: http://biz.yahoo.com/i, or go to www.wiley.com/college/kimmel
Steps 1. Type in a company name, or use the index to find a company name. Choose Profile. Choose
Key Statistics. Perform instruction (a) below. 2. Go back to Profile. Click on the company’s particular industry behind the heading “Industry.”
Perform instructions (b), (c), and (d).
Instructions Answer the following questions. (a) What is the company’s name? What was the company’s current ratio and debt to equity ratio
(a variation of the debt to total assets ratio)? (b) What is the company’s industry? (c) What is the name of a competitor? What is the competitor’s current ratio and its debt to equity
ratio? (d) Based on these measures: Which company is more liquid? Which company is more solvent?
BYP2-6 The opening story described the dramatic effect that investment bulletin boards are hav- ing on the investment world. This exercise will allow you to evaluate a bulletin board discussing a company of your choice.
Address: http://biz.yahoo.com/i, or go to www.wiley.com/college/kimmel
Broadening Your Perspective 93
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 93
94 chapter 2 A Further Look at Financial Statements
Steps 1. Type in a company name, or use the index to find a company name. 2. Choose Msgs or Message Board. (for messages). 3. Read the ten most recent messages.
Instructions Answer the following questions. (a) State the nature of each of these messages (e.g., offering advice, criticizing company, predict-
ing future results, ridiculing other people who have posted messages). (b) For those messages that expressed an opinion about the company, was evidence provided to
support the opinion? (c) What effect do you think it would have on bulletin board discussions if the participants pro-
vided their actual names? Do you think this would be a good policy?
Critical Thinking DECISION MAKING ACROSS THE ORGANIZATION
BYP2-7 As a financial analyst in the planning department for Lindemann Industries, Inc., you have been requested to develop some key ratios from the comparative financial statements. This information is to be used to convince creditors that Lindemann Industries, Inc. is liquid, solvent, and profitable, and that it deserves their continued support. Lenders are particularly concerned about the company’s ability to continue as a going concern.
Here are the data requested and the computations developed from the financial statements:
2012 2011
Current ratio 3.1 2.1 Working capital Up 22% Down 7% Free cash flow Up 25% Up 18% Debt to total assets ratio 0.60 0.70 Net income Up 32% Down 8% Earnings per share $2.40 $1.15
Instructions Lindemann Industries, Inc. asks you to prepare brief comments stating how each of these items supports the argument that its financial health is improving. The company wishes to use these comments to support presentation of data to its creditors. With the class divided into groups, pre- pare the comments as requested, giving the implications and the limitations of each item regarding Lindemann’s financial well-being.
COMMUNICATION ACTIVITY
BYP2-8 T. J. Cerrillo is the chief executive officer of Tomorrow’s Products. T. J. is an expert engi- neer but a novice in accounting.
Instructions Write a letter to T. J. Cerrillo that explains (a) the three main types of ratios; (b) examples of each, how they are calculated, and what they measure; and (c) the bases for comparison in analyzing Tomorrow’s Products’ financial statements.
ETHICS CASE
BYP2-9 At one time, Boeing closed a giant deal to acquire another manufacturer, McDonnell Douglas. Boeing paid for the acquisition by issuing shares of its own stock to the stockhold- ers of McDonnell Douglas. In order for the deal not to be revoked, the value of Boeing’s stock could not decline below a certain level for a number of months after the deal.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 94
During the first half of the year, Boeing suffered significant cost overruns because of ineffi- ciencies in its production methods. Had these problems been disclosed in the quarterly financial statements during the first and second quarter of the year, the company’s stock most likely would have plummeted, and the deal would have been revoked. Company managers spent considerable time debating when the bad news should be disclosed. One public relations manager suggested that the company’s problems be revealed on the date of either Princess Diana’s or Mother Teresa’s funeral, in the hope that it would be lost among those big stories that day. Instead, the company waited until October 22 of that year to announce a $2.6 billion write-off due to cost overruns. Within one week, the company’s stock price had fallen 20%, but by this time the McDonnell Douglas deal could not be reversed.
Instructions Answer the following questions. (a) Who are the stakeholders in this situation? (b) What are the ethical issues? (c) What assumptions or principles of accounting are relevant to this case? (d) Do you think it is ethical to try to “time” the release of a story so as to diminish its effect? (e) What would you have done if you were the chief executive officer of Boeing? (f ) Boeing’s top management maintains that it did not have an obligation to reveal its problems
during the first half of the year. What implications does this have for investors and analysts who follow Boeing’s stock?
“ALL ABOUT YOU” ACTIVITY
BYP2-10 Every company needs to plan in order to move forward. Its top management must con- sider where it wants the company to be in three to five years. Like a company, you need to think about where you want to be three to five years from now, and you need to start taking steps now in order to get there.
Instructions Provide responses to each of the following items. (a) Where would you like to be working in three to five years? Describe your plan for getting there
by identifying between five and 10 specific steps that you need to take in order to get there. (b) In order to get the job you want, you will need a résumé. Your résumé is the equivalent of a
company’s annual report. It needs to provide relevant and reliable information about your past accomplishments so that employers can decide whether to “invest” in you. Do a search on the Internet to find a good résumé format. What are the basic elements of a résumé?
(c) A company’s annual report provides information about a company’s accomplishments. In order for investors to use the annual report, the information must be reliable; that is, users must have faith that the information is accurate and believable. How can you provide assur- ance that the information on your résumé is reliable?
(d) Prepare a résumé assuming that you have accomplished the five to 10 specific steps you iden- tified in part (a). Also, provide evidence that would give assurance that the information is reliable.
FASB CODIFICATION ACTIVITY
BYP2-11 If your school has a subscription to the FASB Codification, go to http://aaahq.org/ ascLogin.cfm to log in and prepare responses to the following.
Instructions (a) Access the glossary (“Master Glossary”) at the FASB Codification website to answer the fol-
lowing. (1) What is the definition of current assets? (2) What is the definition of current liabilities?
(b) A company wants to offset its accounts payable against its cash account and show a cash amount net of accounts payable on its balance sheet. Identify the criteria (found in the FASB Codification) under which a company has the right of set off. Does the company have the right to offset accounts payable against the cash account?
Broadening Your Perspective 95
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 95
96 chapter 2 A Further Look at Financial Statements
Answers to Insight and Accounting Across the Organization Questions
p. 60 Can a Company Be Too Liquid? Q: What can various company managers do to ensure that working capital is managed efficiently to maximize net income? A: Marketing and sales managers must understand that by extending generous repayment terms, they are expanding the company’s receivables balance and slowing the company’s cash flow. Production managers must strive to minimize the amount of excess inventory on hand. Managers must coordinate efforts to speed up the collection of receivables, while also ensuring that the company pays its payables on time but never too early.
p. 61 When Debt Is Good Q: Discuss the difference in the debt to total assets ratio of Microsoft and General Motors. A: Microsoft has a very low debt to total assets ratio. The company is in a rap- idly changing industry and thus should try to minimize the risk associated with increased debt. Also, because Microsoft generates significant amounts of cash and has minimal needs for large invest- ments in plant assets, it does not need to borrow a lot of cash. General Motors needs to make huge investments in plant assets, and it has a very large credit operation. Thus, it has large borrowing needs.
p. 64 The Korean Discount Q: What is meant by the phrase “make the country’s businesses more transparent”? Why would increasing transparency spur economic growth? A: Transparency refers to the extent to which outsiders have knowledge regarding a company’s financial performance and financial position. If a company lacks transparency, its financial reports do not adequately inform investors of critical information that is needed to make investment decisions. If corporate trans- parency is increased, investors will be more willing to supply the financial capital that businesses need in order to grow, which would spur the country’s economic growth.
p. 65 What Do These Companies Have in Common? Q: What problems might Best Buy’s year-end create for analysts? A: First, if Best Buy’s competitors use a different year-end, then when you compare their financial results, you are not comparing performance over the same period of time or financial position at the same point in time. Also, by not picking a particular date, the number of weeks in Best Buy’s fiscal year will change. For example, fiscal years 2008 and 2009 had 52 weeks, but fiscal year 2007 had 53 weeks.
Answers to Self-Test Questions
1. d 2. a 3. c 4. c 5. b 6. a 7. c 8. b 9. d 10. d 11. a 12. a 13. c 14. c 15. b
IFRS A Look at IFRS The classified balance sheet, although generally required internationally, contains certain varia- tions in format when reporting under IFRS.
KEY POINTS • IFRS recommends but does not require the use of the title “statement of financial position”
rather than balance sheet.
• The format of statement of financial position information is often presented differently under IFRS. Although no specific format is required, most companies that follow IFRS present state- ment of financial position information in this order:
• Noncurrent assets
• Current assets
• Equity
• Noncurrent liabilities
• Current liabilities
• IFRS requires a 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.
• Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last.
• Some companies report the subtotal net assets, which equals total assets minus total liabilities. See, for example, the statement of financial position of Zetar plc in Appendix C.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 96
• IFRS has many differences in terminology that you will notice in this textbook. For example, in the sample statement of financial position illustrated below, notice in the investment category that stock is called shares, and in the equity section common stock is called share capital–ordinary.
A Look at IFRS 97
FRANKLIN CORPORATION Statement of Financial Position
October 31, 2012
Assets
Intangible assets Patents $ 3,100
Property, plant, and equipment Land $10,000 Office equipment $24,000 Less: Accumulated depreciation 5,000 19,000 29,000
Long-term investments Investment in shares of Walters Corp. 5,200 Investment in real estate 2,000 7,200
Current assets Prepaid insurance 400 Supplies 2,100 Inventories 3,000 Notes receivable 1,000 Accounts receivable 7,000 Short-term investments 2,000 Cash 6,600 22,100
Total assets $61,400
Equity and Liabilities
Equity Share capital—ordinary $20,000 Retained earnings 14,050 $34,050
Non-current liabilities Mortgage note payable 10,000 Notes payable 1,300 11,300
Current liabilities Notes payable 11,000 Accounts payable 2,100 Salaries payable 1,600 Unearned revenue 900 Interest payable 450 16,050
Total equity and liabilities $61,400
• Both IFRS and GAAP require disclosures about (1) accounting policies followed, (2) judgments that management has made in the process of applying the entity’s accounting policies, and (3) the key assumptions and estimation uncertainty that could result in a material adjustment to the carrying amounts of assets and liabilities within the next financial year.
• Comparative prior-period information must be presented and financial statements must be pre- pared annually.
• Both GAAP and IFRS are increasing the use of fair value to report assets. However, at this point IFRS has adopted it more broadly. As examples, under IFRS companies can apply fair value to property, plant, and equipment; natural resources; and in some cases intangible assets.
• Recently, the IASB and FASB completed the first phase of a jointly created conceptual frame- work. In this first phase, they agreed on the objective of financial reporting and a common set of desired qualitative characteristics. These were presented in the Chapter 2 discussion.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 97
98 chapter 2 A Further Look at Financial Statements
• The monetary unit assumption is part of each framework. However, the unit of measure will vary depending on the currency used in the country in which the company is incorporated (e.g., Chinese yuan, Japanese yen, and British pound).
• The economic entity assumption is also part of each framework although some cultural differ- ences result in differences in its application. For example, in Japan many companies have formed alliances that are so strong that they act similar to related corporate divisions although they are not actually part of the same company.
LOOKING TO THE FUTURE The IASB and the FASB are working on a project to converge their standards related to finan- cial statement presentation. A key feature of the proposed framework is that each of the state- ments will be organized in the same format, to separate an entity’s financing activities from its operating and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial posi- tion would also be used in the income statement and the statement of cash flows. The project has three phases. You can follow the joint financial presentation project at the following link: http://www.fasb.org/project/financial_statement_presentation.shtml.
The IASB and the FASB face a difficult task in attempting to update, modify, and complete a converged conceptual framework. For example, how do companies choose between information that is highly relevant but difficult to verify versus information that is less relevant but easy to ver- ify? How do companies define control when developing a definition of an asset? Is a liability the future sacrifice itself or the obligation to make the sacrifice? Should a single measurement method, such as historical cost or fair value, be used, or does it depend on whether it is an asset or liability that is being measured? It appears that the new document will be a significant improve- ment over its predecessors and will lead to principle-based standards, which will help financial statement users make better decisions.
IFRS Self-Test Questions 1. 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. 2. 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.
3. 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.
4. 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. 5. Companies that follow IFRS to prepare a statement of financial position generally use the fol-
lowing 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.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 98
IFRS Concepts and Application IFRS2–1 In what ways does the format of a statement of financial of position under IFRS often differ from a balance sheet presented under GAAP?
IFRS2–2 Do the IFRS and GAAP conceptual frameworks differ in terms of the objective of finan- cial reporting? Explain.
IFRS2–3 What terms commonly used under IFRS are synonymous with common stock and bal- ance sheet?
IFRS2–4 The statement of financial position for Diaz Company includes the following accounts: Accounts Receivable £12,500; Prepaid Insurance £3,600; Cash £15,400; Supplies £5,200; and Short-Term Investments £6,700. Prepare the current assets section of the statement of financial position, listing the accounts in proper sequence.
IFRS2–5 Zurich Company recently received the following information related to the company’s December 31, 2012, statement of financial position.
Inventories CHF 2,900 Short-term investments CHF 120 Cash 13,400 Accumulated depreciation 5,700 Equipment 21,700 Accounts receivable 4,300 Investments in ordinary
shares (long-term) 6,500
Prepare the assets section of the company’s classified statement of financial position.
IFRS2–6 The following information is available for Karr Bowling Alley at December 31, 2012.
Buildings $128,800 Share Capital—Ordinary $100,000 Accounts Receivable 14,520 Retained Earnings 15,000 Prepaid Insurance 4,680 Accumulated Depreciation—Buildings 42,600 Cash 18,040 Accounts Payable 12,300 Equipment 62,400 Notes Payable 97,780 Land 64,000 Accumulated Depreciation—Equipment 18,720 Insurance Expense 780 Interest Payable 2,600 Depreciation Expense 7,360 Bowling Revenues 14,180 Interest Expense 2,600
Prepare a classified statement of financial position; assume that $13,900 of the notes payable will be paid in 2013.
IFRS2–7 Brian Hopkins is interested in comparing the liquidity and solvency of a U.S. software company with a Chinese competitor. Is this possible if the two companies report using different currencies?
INTERNATIONAL COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Zetar plc
IFRS2–8 The financial statements of Zetar plc are presented in Appendix C. The company’s complete annual report, including the notes to its financial statements, is available at www.zetarplc.com.
Instructions Identify five differences in the format of the statement of financial position used by Zetar plc com- pared to a company, such as Tootsie Roll, that follows GAAP. (Tootsie Roll’s financial statements are available in Appendix A.)
Answers to IFRS Self-Test Questions
1. d 2. d 3. b 4. c 5. c
A Look at IFRS 99
●●✓Remember to go back to the navigator box on the chapter opening page and check off your completed work.
c02AFurtherLookatFinancialStatements.qxd 7/27/10 9:39 AM Page 99