978-1133939283 Chapter 5 Lecture Note

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Chapter 5

Foundations of Financial Reporting and

the Classied Balance Sheet

Learning Objectives

1. Describe the objective of nancial reporting, and identify the conceptual framework

underlying accounting information.

2. Identify and dene the basic components of nancial reporting, and prepare a classied

balance sheet.

3. Use classied nancial statements to evaluate liquidity and protability.

Section 1: Concepts

Concepts

 Relevance

oPredictive value

oConrmative value

oMateriality

 Faithful representation

oCompleteness

oNeutrality

oFree from material error

 Enhancing qualitative characteristics

oComparability

oVeriability

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.

or posted to a publicly accessible website, in whole or in part.

Chapter 5: Foundations of Financial Reporting and the Classied 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. Conrmative 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. Veriability

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 signicant

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 conrmative value (or both).

This information is also subject to materiality.

or posted to a publicly accessible website, in whole or in part.

Chapter 5: Foundations of Financial Reporting and the Classied 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, veriability 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 justication 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 dene depreciation, but

do not attempt to teach methods at this time.

Exhibit 1 should be used to sort out the denitions of terms. GAAP provides specic

applications of usefulness, relevance, and reliability. Students should commit the specic

terms to memory.

or posted to a publicly accessible website, in whole or in part.

Chapter 5: Foundations of Financial Reporting and the Classied 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 signicance 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 denition 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 classied balance sheet

 Prepare a classied balance sheet

Lecture Outline

I. Classied nancial statements are general-purpose external nancial statements that

are divided into subcategories to provide more useful information to the reader.

III. A classied 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 classied 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 classication 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 classied 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

Classied nancial statements are general-purpose external nancial statements that

are divided into subcategories to provide more useful information to the reader. The balance

or posted to a publicly accessible website, in whole or in part.

Chapter 5: Foundations of Financial Reporting and the Classied Balance Sheet

Instructor’s Manual, p. 5

sheets presented thus far categorize accounts as assets, liabilities, and owner’s equity. On a

classied 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 classied 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 classied 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.

or posted to a publicly accessible website, in whole or in part.

Chapter 5: Foundations of Financial Reporting and the Classied 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 Classied Balance Sheet

 Exhibit 3 Classied Balance Sheet for Bonali Company

 Exhibit 4 Classied 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 dening 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 dene the terms used.

Short Exercises 3 and 4 and Exercises 3A and 4A pertain to the classication of accounts on

the balance sheet. It is often benecial 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

 Protability

oProt margin

oAsset turnover

oReturn on assets

oDebt to equity ratio

oReturn on equity

or posted to a publicly accessible website, in whole or in part.

Chapter 5: Foundations of Financial Reporting and the Classied 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. Protability may be measured several ways.

A. Prot 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

Classied nancial statements help the reader evaluate liquidity and protability.

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.

Protability is the ability to earn a satisfactory income. To draw conclusions, measures of

protability must be compared with past performance and industry averages. Five measures

of protability are the prot margin, asset turnover, return on assets, debt to equity ratio,

and return on equity.

The prot 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 prot 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

 Prot Margin

 Asset Turnover

 Return on Assets

 Debt to Equity Ratio

 Return on Equity

Teaching Strategy

or posted to a publicly accessible website, in whole or in part.

Chapter 5: Foundations of Financial Reporting and the Classied 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 signicant 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 prot 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.

or posted to a publicly accessible website, in whole or in part.