Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
Chapter 5
Foundations of Financial Reporting and
the Classied Balance Sheet
Learning Objectives
1. Describe the objective of nancial reporting, and identify the conceptual framework
underlying accounting information.
2. Identify and dene the basic components of nancial reporting, and prepare a classied
balance sheet.
3. Use classied nancial statements to evaluate liquidity and protability.
Section 1: Concepts
Concepts
Relevance
oPredictive value
oConrmative value
oMateriality
Faithful representation
oCompleteness
oNeutrality
oFree from material error
Enhancing qualitative characteristics
oComparability
oVeriability
oTimeliness
oUnderstandability
oCost constraint
Accounting conventions
oConsistency
oFull disclosure
oConservatism
Lecture Outline
I. Objective of nancial reporting
A. Assess cash 1ow prospects.
1. Ability to pay dividends, interest, and returns to capital
B. Assess stewardship
1. Provide information about business resources, claims to those resources, and
changes in them
C. General-purpose external nancial statements consist of the balance sheet,
income statement, statement of retained earnings, and statement of cash 1ows.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 5: Foundations of Financial Reporting and the Classied Balance Sheet
Instructor’s Manual, p. 2
II. Qualitative characteristics facilitates a user’s interpretations of accounting information
A. Information should be relevant, meaning it has direct bearing on a decision.
1. Predictive value
2. Conrmative value
3. Materiality
B. The information should be a faithful representation of the entity.
1. Complete, neutral, and free from material error
2. Information does not have to be absolutely accurate but major uncertainties
should be disclosed.
C. Four qualitative characteristics complement the quality of information.
1. Comparability
2. Veriability
3. Timeliness
4. Understandability
III. Accounting conventions are constraints on accounting and the preparation of nancial
statements to better enable the user to understand the information being presented.
IV. Consistency
A. Once a company has adopted an accounting procedure, it must use it from one
period to the next unless otherwise noted.
V. Full disclosure (transparency)
A. Financial statements must present all information relevant to users’ understanding
of the statements.
B. Explanatory notes must disclose changes in accounting procedures and signicant
events occurring after balance sheet dates.
VI. Conservatism
A. When given a choice between two equally acceptable procedures, choose the one
least likely to overstate assets or income.
B. Conservatism is useful, but can be abused, so accountants should only depend on
it when uncertain about which procedure or estimate to use.
VII. Under the Sarbanes-Oxley Act, the CEO and CFO of public companies must certify the
nancial statements and the system of internal control.
Summary
Financial reporting must enable the user to do two things: assess cash 1ow prospects and
assess stewardship. The nancial statements—the balance sheet, the income statement,
the statement of owner’s equity, and the statement of cash 1ows—are important, but not
the only outputs of the accounting system. Management’s explanations, including
underlying assumptions, methods, and estimates in the nancial reports are also important
components.
Accounting attempts to provide decision makers with information that displays qualitative
characteristics, or standards, of understandability and usefulness, by which to judge the
accounting information. Understandability is the qualitative characteristic that enables users
to perceive its meaning, often by utilizing accounting conventions, or rules of thumb, used in
preparing nancial statements. Usefulness is the qualitative characteristic that is relevant
and a faithful representation.
1. Relevance means that the information has a direct bearing on a decision. To be
relevant, information has either predictive value or conrmative value (or both).
This information is also subject to materiality.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 5: Foundations of Financial Reporting and the Classied Balance Sheet
Instructor’s Manual, p. 3
2. Faithful representation means that the accounting information is reliable depiction
of what it purports to represent. To be faithful, information must be complete, neutral,
and free from material error.
3. Additional qualitative characteristics that have been established by FASB to interpret
nancial statements are comparability, veriability timeliness and
understandability.
Financial statements must conform to accounting conventions in order to be useful.
Accounting conventions aBect how and what information is presented in nancial
statements. To help make nancial statements more meaningful, accountants depend on the
following conventions, or rules of thumb, in recording transactions and preparing nancial
statements:
The consistency convention requires that once a company has adopted an accounting
procedure, it must use it from one period to the next unless a note to the nancial
statements informs users of a change in procedure. If a company does change a procedure,
it must disclose both the dollar eBect on the statements and justication for the change.
The full disclosure (or transparency) convention requires that a company’s nancial
statements and their accompanying notes present all information relevant to the users’
understanding of the statements.
The conservatism convention holds that when faced with two equally acceptable
accounting procedures, the accountant should choose the one that is least likely to
overstate assets and income. Applying the lower-of-cost-or-market rule to inventory
valuation is an example of conservatism.
Under the Sarbanes-Oxley Act, the CEO and CFO of public companies must certify the
nancial statements and the system of internal control.
Relevant Examples and Exhibits
Exhibit 1 Concepts Underlying Financial Reporting
Teaching Strategy
In learning the processes required in the accounting cycle, students may lose sight of the
ultimate purpose to which each step leads: the presentation of nancial statements for
various uses. This section is an opportunity to review a list of users of nancial information.
Now that students have a new understanding of the construction of nancial statements, it
is helpful to discuss various accounts and their relationship to the whole statement to draw
attention to a particular user and use (e.g., a loan oCcer at a bank may be particularly
interested in total liabilities in relation to total assets).
Up to this point in the course, students have been trained to expect total accuracy in all
accounting transactions. This is their rst exposure to the concept of estimation of amounts
on nancial statements. Discuss this concept. Using depreciation as an example helps
students understand what is meant by approximation. Take care to dene depreciation, but
do not attempt to teach methods at this time.
Exhibit 1 should be used to sort out the denitions of terms. GAAP provides specic
applications of usefulness, relevance, and reliability. Students should commit the specic
terms to memory.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 5: Foundations of Financial Reporting and the Classied Balance Sheet
Instructor’s Manual, p. 4
The topic of qualitative characteristics of accounting information lends itself well to an essay
question; a reconstruction of Exhibit 1, with some terminology left blank, is an appropriate
test of comprehension.
Each of the characteristics in this section should be discussed in depth. For the continuing
accounting student, these are terms that are used in the literature and should be a guiding
force in decision making. Although this section is heavy on theory, it can be conceptually
linked to the mechanics of the accounting process with the use of examples. Most
accounting students, when rst exposed to these terms, do not see the signicance of these
concepts. It may be wise to force a focus on this material by including these topics on an
exam.
Exercise 1A is appropriate for classroom discussion of this topic. Cases 1 and 2 are excellent
problems for conceptual analyses of this topic.
Essay questions requiring denition of terms are an appropriate subjective-test approach to
this topic; matching terms with the concepts underlying those terms is an appropriate
objective-test approach to this topic.
Section 2: Accounting Applications
Accounting Applications
Identify components of a classied balance sheet
Prepare a classied balance sheet
Lecture Outline
I. Classied nancial statements are general-purpose external nancial statements that
are divided into subcategories to provide more useful information to the reader.
III. A classied balance sheet divides assets, liabilities, and owner’s equity into
subcategories to facilitate decision making.
IV. There are usually four categories of assets on the classied balance sheet. These
categories are listed in declining order of liquidity. (Some companies use another
category called other assets to group all assets other than current assets and property,
plant, and equipment.)
A. Current assets
1. The normal operating cycle, a concept used in the classication of assets, is
the time a company needs to go from spending cash to receiving cash.
B. Investments
C. Property, plant, and equipment
D. Intangible assets
V. Liabilities on the classied balance sheet are usually divided into two categories.
A. Current liabilities
B. Long-term liabilities
VI. In a sole proprietorship, the owner’s equity section shows the capital in the owner’s
name at an amount equal to the net assets of the company.
Summary
Classied nancial statements are general-purpose external nancial statements that
are divided into subcategories to provide more useful information to the reader. The balance
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 5: Foundations of Financial Reporting and the Classied Balance Sheet
Instructor’s Manual, p. 5
sheets presented thus far categorize accounts as assets, liabilities, and owner’s equity. On a
classied balance sheet, assets are usually divided into four categories: (1) current assets;
(2) investments; (3) property, plant, and equipment; and (4) intangible assets. These
categories are usually listed in the order of their presumed ease of conversion into cash.
(Some companies use another category called other assets to group all assets other than
current assets and property, plant, and equipment.)
Current assets comprise cash and other assets that a company can reasonably expect to
convert to cash, sell, or use up within one year or its normal operating cycle, whichever is
longer. The normal operating cycle of a company is the average time it needs to go from
spending cash to receiving cash. Cash, short-term investments, accounts receivable, notes
receivable, prepaid expenses, supplies, and inventory are current assets.
Investments include assets, usually long-term, that are not used in normal business
operations and that management does not plan to convert to cash within the next year.
Included in this category are securities held for long-term investment, long-term notes
receivable, land held for future use, plant and equipment not used in the business, special
funds, and a controlling interest in another company.
Property, plant, and equipment are tangible long-term assets used in the continuing
operation of a business. They represent a place to operate (land and buildings) and the
equipment used to produce, sell, and deliver goods or services. They are also called
operating assets, xed assets, tangible assets, long-lived assets, or plant assets. This
category includes land, buildings, delivery equipment, machinery, oCce equipment, and
natural resources owned by the company, if they are used in the regular course of business.
All except land are subject to depreciation.
Intangible assets are long-term assets with no physical substance whose value stems from
the rights or privileges they extend to their owners. Examples are patents, copyrights,
goodwill, franchises, and trademarks. Goodwill only arises in an acquisition of another
company and is reviewed each year for impairment.
The liabilities of a classied balance sheet are divided into two categories: current liabilities
and long-term liabilities.
Current liabilities consist of obligations due to be paid or performed within one year or
within the normal operating cycle of the business, whichever is longer. They are paid from
current assets or from the incurring of new short-term liabilities. Examples are notes
payable, accounts payable, the current portion of long-term debt, salaries and wages
payable, and customer advances (unearned revenues).
Long-term liabilities comprise debts that fall due more than one year in the future or
beyond the normal operating cycle, which will be paid from noncurrent assets. Examples are
mortgages payable, long-term notes payable, bonds payable, employee pension obligations,
and long-term leases.
The owner’s equity section of a classied balance sheet can be called owner’s equity,
partners’ equity, or stockholders’ equity. The exact name depends on whether the
business is a sole proprietorship, a partnership, or a corporation.
In a corporation, the stockholders’ equity section consists of contributed capital and retained
earnings. Contributed capital (sometimes called paid-in capital) is the amount invested by
the stockholders. It is divided further into the par value of the issued stock and the paid-in,
or contributed, capital in excess of the par value per share. Retained earnings (sometimes
called earned capital) re1ect the earnings record of the company since its beginning.
Dividends (assets distributed to stockholders) reduce the Retained Earnings account
balance, as do net losses.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 5: Foundations of Financial Reporting and the Classied Balance Sheet
Instructor’s Manual, p. 6
In a sole proprietorship or partnership, the owner’s equity section shows the capital in the
owner’s name at an amount equal to the net assets of the company. Each name is followed
by the word “Capital” and the dollar amount of investment as of the balance sheet date.
Relevant Examples and Exhibits
Exhibit 2 Classied Balance Sheet
Exhibit 3 Classied Balance Sheet for Bonali Company
Exhibit 4 Classied Balance Sheet Groups Accounts into Useful Categories
Teaching Strategy
For this section, attention to detail is of the utmost importance. Take the time to review
Exhibit 3 and the sections, account titles, and calculations on the balance sheet. At rst,
students are intimidated by the length and complexity of this statement. Assure them that
the basic accounting equation is still represented and that the broad account categories are
unchanged, but that detail has been added. Care in dening subcategories is helpful (current
assets, investments, and so on).
A review of the three basic forms of business is helpful. Point out how the owner’s or
stockholders’ equity section for each form is presented. There may be particular confusion
about the owner’s equity section. It is best to introduce the topic, point out the account
titles, indicate that they are “equity” accounts, and dene the terms used.
Short Exercises 3 and 4 and Exercises 3A and 4A pertain to the classication of accounts on
the balance sheet. It is often benecial to introduce a real company’s balance sheet and
discuss the diBerences and similarities to the text discussion of a balance sheet.
Section 3: Business Applications
Business Applications
Liquidity
oWorking capital
oCurrent ratio
Protability
oProt margin
oAsset turnover
oReturn on assets
oDebt to equity ratio
oReturn on equity
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 5: Foundations of Financial Reporting and the Classied Balance Sheet
Instructor’s Manual, p. 7
Lecture Outline
I. Liquidity measures a company’s ability to pay its bills when they fall due.
A. Working capital is current assets minus current liabilities.
B. The current ratio is current assets divided by current liabilities.
VII. Protability may be measured several ways.
A. Prot margin—net income divided by net sales
B. Asset turnover—net sales divided by average total assets
C. Return on assets—net income divided by average total assets
D. Debt to equity ratio—total liabilities divided by total equity
E. Return on equity—net income divided by average owner’s equity
Summary
Classied nancial statements help the reader evaluate liquidity and protability.
Liquidity measures a company’s ability to pay its bills when they are due and to provide for
unanticipated needs for cash. Two measures of liquidity are working capital and the current
ratio. Working capital equals current assets minus current liabilities. It equals the current
asset amount that would remain if all the current debts were paid or obligations were
performed. The current ratio equals current assets divided by current liabilities. A current
ratio of 1.0, for example, shows that current assets are barely enough to settle current
liabilities; a current ratio of 2.0 is considered more satisfactory.
Protability is the ability to earn a satisfactory income. To draw conclusions, measures of
protability must be compared with past performance and industry averages. Five measures
of protability are the prot margin, asset turnover, return on assets, debt to equity ratio,
and return on equity.
The prot margin shows the percentage of each sales dollar that result in net income. It
equals net income divided by net sales. A 12.5 percent prot margin, for example, means
that 12.5 cents have been earned on each dollar of sales.
Asset turnover shows how eCciently assets are used to produce sales. It equals net sales
divided by average total assets.
Return on assets shows how eCciently a company uses its assets to produce income. It
equals net income divided by average total assets.
The debt to equity ratio shows the proportion of a business’s assets that is nanced by
creditors and the proportion nanced by owners. It equals total liabilities divided by total
equity. A debt to equity ratio of 1.0 indicates equal nancing by creditors and owners.
Return on equity (return on owner’s investment) relates the amount earned by a business
to the owner’s investment in the business. It equals net income divided by average owner’s
equity.
Relevant Examples and Exhibits
Current Ratio
Prot Margin
Asset Turnover
Return on Assets
Debt to Equity Ratio
Return on Equity
Teaching Strategy
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 5: Foundations of Financial Reporting and the Classied Balance Sheet
Instructor’s Manual, p. 8
It is in this section that students begin to see relationships between account categories and
the nancial health of a company. Although ratio analysis may be new to students, the math
is simple. As each ratio is introduced, care should be taken to discuss the meaning behind it.
Relate ratio analysis to industry averages as a measure of nancial stability for an individual
company.
This section provides a good opportunity to refer students to the library or the Internet for
some research into ratios of companies with which they are familiar. (Moody’s or Standard &
Poor’s can be suggested as a resource.)
Short Exercises 5, 6, and 7, Exercises 5A through 8A, and Cases 3 and 7 apply to this
section.
Student Engagement Tactics
1. This assignment demonstrates the components and use of an annual report. Have
students obtain an annual report from a public company’s website or provide each
student with a copy of an annual report for a diBerent company. You can use last year’s
annual reports that you keep on le in your oCce and no longer need.
2. Announce the assignment in advance or hand out the reports in advance of the day
they will be used in class. Ask students to identify the parts of the annual report and to
calculate the ratios called for in Case 7 for the most recent year shown in the report.
Also ask students to prepare a short memorandum that explains the nature of the
company they chose with a list of some signicant occurrences in the past year. If you
wish, you can ask for other information as long as it is typical information that can be
obtained from an annual report.
3. In class, go through the components of the annual report, asking students to tell what
they found for their reports. For instance, there will be considerable variation in the
terminology of parts of statements. List the diBerent names of the balance sheet and
income statement on the board. Find out what kinds of notes the various companies
have. Determine if anyone has an auditor’s report that is more or less than three
paragraphs and determine why. Encourage interaction among class members, and be
prepared to ask questions yourself.
4. Prepare columns on the board for such ratios as prot margin, asset turnover, return on
assets, debt to equity, and return on equity. First discuss diCculties students may have
had in computing these ratios. Then begin listing the ratios as given to you by each
student. The list will show both the variation in performance of diBerent companies and
the interrelationships among the ratios. Discuss how to tell if a company is doing
poorly, average, or well.
5. An alternative way to conduct this activity is to form groups and have each group study
one company. This approach has the advantage of promoting group interaction and
reducing the number of companies that need to be dealt with in class.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
