2-1
CHAPTER 2
A Further Look at
Financial Statements
Learning Objectives
1. Identify the sections of a classified balance sheet.
2. Identify tools for analyzing financial statements and compute ratios for analyzing a
company’s profitability.
3. Explain the relationship between a retained earnings statement and a statement of
stockholders’ equity.
4. Identify and compute ratios for analyzing a company’s liquidity and solvency using a
balance sheet.
2-2
Chapter Outline
Learning Objective 1 – Identify the Sections of a Classified Balance Sheet.
In a classified balance sheet, companies often group similar assets and similar liabilities
together using standard classifications and sections. This is useful because items within the
groups have similar economic characteristics. The groupings help users determine:
A classified balance sheet generally contains the following standard classifications:
Current Assets
▪ Assets that are expected to be converted to cash or used up in the business within one
year or one operating cycle whichever is longer.
▪ Examples of current assets: cash, short-term investments (which include short-term
U.S. government securities), receivables (accounts receivable, notes receivable, and
interest receivable), inventories, and prepaid expenses (rent, supplies, insurance, and
advertising).
TEACHING TIP
(a) Discuss the difference between notes receivable and accounts receivable; different types
of prepaid expenses; and the fact that inventory, supplies, and prepaid expenses will
become expenses when they are used up. Explain why these assets are classified as
current. (b) Discuss the concept of short-term investments.
Long-Term Investments
▪ Assets that can be converted into cash, but whose conversion is not expected within
one year.
▪ These include long-term assets not currently used in the company’s operations (i.e.,
land, buildings, etc.) and investments in stocks and bonds of other corporations.
2-3
TEACHING TIP
Explain to students that there are individuals in large companies who do nothing but take
care of long-term investments.
Discuss the difference between short-term and long-term investments in stocks and bonds of
other corporations.
Example: A homebuilder has the following assets: (1) lots in a subdivision that are ready
for sale to buyers; (2) land on which the corporate office building sits; and (3) land several
Property, Plant, and Equipment
▪ Assets with relatively long useful lives.
▪ Assets currently used in operating the business.
▪ Sometimes called fixed assets or plant assets.
▪ Examples include land, buildings, machinery, equipment, and furniture and fixtures.
▪ Record these assets at cost and depreciate them (except land) over their useful
lives. The full purchase price is not expensed in the year of purchase because the
assets will be used for more than one accounting period.
o Depreciation is the practice of allocating the cost of assets to a number of years.
TEACHING TIP
Explain that depreciation is not a valuation of assets. It is the allocation of their cost over the
periods in which they will benefit the business. Many students believe the balance sheet
Intangible Assets
▪ Noncurrent assets.
▪ Assets that have no physical substance.
▪ Examples are goodwill, patents, copyrights, and trademarks or trade names.
TEACHING TIP
Briefly discuss types of intangible assets. Encourage students to think about companies that
have large investments in intangible assets. Remind students that this topic is discussed in
more detail in Chapter 9.
2-4
Current Liabilities
▪ Obligations that are to be paid within the coming year or operating cycle whichever
is longer.
▪ Common examples are notes payable, accounts payable, wages payable, bank
loans payable, interest payable, taxes payable, and current maturities of long-term
TEACHING TIP
(a) Discuss the following payables: wages payable, interest payable, taxes payable, etc.
Long-Term Liabilities
▪ Obligations expected to be paid after one year.
▪ Liabilities in this category include bonds payable, mortgages payable, long-term
notes payable, lease liabilities, and pension liabilities.
TEACHING TIP
Bonds have been mentioned several times. Students need to understand the difference
between notes payable and bonds payable. Also discuss the difference between interest
payable and notes or bonds payable.
Stockholders’ Equity: Stockholders’ equity consists of two parts:
▪ Common Stock – investments of assets into the business by the stockholders.
▪ Retained Earnings – income retained for use in the business.
TEACHING TIP
more detail in Chapter 11. Until then, they will work with common stock.
2-5
Learning Objective 2 – Identify Tools for Analyzing Financial Statements and
Ratios for Computing a Company’s Profitability.
Ratio analysis expresses the relationship among selected items of financial statement
data.
▪ A ratio expresses the mathematical relationship between one quantity and another.
▪ Ratios shed light on company performance
o Intracompany comparisons – covers two years for the same company
o Industry-average comparisons – based on average ratios for particular
industries
o Intercompany comparisons – based on comparisons with a competitor in the
same industry.
TEACHING TIP
Discuss your preference for rounding. Explain how to compute percentages. Encourage
students to use a spreadsheet for computations and presentation. Also encourage them to
TEACHING TIP
Discuss ways for students to find industry averages and ratios from sources on the web and
in the library. Encourage them to start watching shows on the financial networks and reading
business periodicals as well as the business section of newspapers. Ask them to share
interesting information with the class.
Using the Income Statement—Creditors and investors are interested in evaluating
profitability. Profitability is frequently used as a test of management’s effectiveness. To
supplement an evaluation of the income statement, ratio analysis is used. Profitability
ratios – measure the operating success of a company for a given period of time.
▪ Earnings per share
o Is a profitability ratio that measures the net income earned on each share of
common stock.
o Is computed by dividing (net income less preferred dividends) by the average
number of common shares outstanding during the year.
2-6
TEACHING TIP
Ask students to watch one of the financial channels for at least 30 minutes and report on the
references to earnings per share. If you use a discussion board, students can post their
comments on it. This is an efficient way to share the information with the class without taking
up too much classroom time.
Learning Objective 3 – Explain the Relationship Between a Retained Earnings
Statement and a Statement of Stockholders’ Equity.
Retained Earnings Statement
▪ Describes the events that caused changes in the retained earnings account for the
period.
Statement of Stockholders’ Equity
▪ Reports all changes in stockholders’ equity accounts (i.e., capital stock issued or retired).
TEACHING TIP
Walk through Best Buy’s Statement of Stockholders’ Equity. Explain how the Statement of
Stockholders’ Equity provides more information than a Retained Earnings Statement.
Learning Objective 4 – Identify and Compute Ratios for Analyzing a Company’s
Liquidity and Solvency Using a Balance Sheet.
Using A Classified Balance Sheet—An analysis of the relationship between a
company’s assets and liabilities can provide users with information about the firm’s
liquidity and solvency.
▪ Liquidity – The ability to pay obligations expected to come due within the next
year or operating cycle. Two measures of liquidity include:
o Working capital
• Measure of short-term ability to pay obligations
• Excess of current assets over current liabilities
• Positive working capital (Current Assets > Current Liabilities)
o Current ratio
• Measure of short-term ability to pay obligations
• Computed by dividing current assets by current liabilities
• More dependable indicator of liquidity than working capital
2-7
• Does not take into account the composition of current assets (like slow-moving
inventory versus cash)
TEACHING TIP
Explain that a 1.60:1 ratio means that for every $1 of current liabilities, the company has
$1.60 in current assets.
Also, students need to be aware of the fact that the composition of the assets may be very
important. For example if a company had most of its current assets in cash it could be more
▪ Solvency – The ability of a company to pay interest as it comes due and to repay the
balance of debt due at its maturity. Solvency ratios include:
o Debt to Total Assets Ratio
• Measures the percentage of assets financed by creditors
• The higher the percentage of debt financing, the riskier the company.
• Computed by dividing total debt (both current and long-term liabilities) by total
assets
TEACHING TIP
Compare ratios to tests performed by a doctor. Each test provides information. The doctor
must ask the patient questions and then review the results of all tests before making a
Learning Objective 5 – Use the Statement of Cash Flows to Evaluate Solvency.
In the statement of cash flows, cash provided by operating activities indicates the
cash-generating capability of the company. However, cash provided by operating
activities fails to take into account that a company must invest in new property, plant,
and equipment and at least maintain dividends at current levels to satisfy investors.
2-8
TEACHING TIP
Go over the free cash flow calculation for Best Buy.
Ask students to compute the free cash flow for a company and report their findings to the class.
Learning Objective 6 – Explain the Meaning of Generally Accepted Accounting
Principles.
Generally Accepted Accounting Principles (GAAP) are a set of rules and practices that
provide answers to the following questions.
▪ How does a company decide on the type of financial information to disclose?
The Securities and Exchange Commission (SEC) is a U.S. government agency that
oversees U.S. financial markets and accounting standard-setting bodies.
The primary accounting standard-setting body in the U. S. is the Financial Accounting
Standards Board (FASB).
The International Accounting Standards Board (IASB) sets standards called International
Financial Reporting Standards (IFRS) for many countries outside the U.S.
The Public Company Accounting oversight Board (PCAOB) determines auditing
standards and reviews the performance of auditing firms.
TEACHING TIP
Remind students that financial statements consist of the income statement, retained
earnings statement, balance sheet, and statement of cash flows. Again, it may be good to
remind them that there are internal and external users.
TEACHING TIP
2-9
Learning Objective 7 – Discuss Financial Reporting Concepts.
Qualities of Useful Information—To be useful, information should possess two
fundamental qualities: relevance and faithful representation.
▪ Relevance – if information has the ability to make a difference in a decision
scenario, it is relevant. Accounting information is considered relevant if it
provides information that
o has predictive value—helps provide accurate expectations about the
future
TEACHING TIP
When you were trying to decide what to wear to class, did it matter whether you were going
to an English class or an Accounting class? No. That information was not relevant.
TEACHING TIP
Materiality allows firms to modify GAAP. Assume a firm buys a new electric pencil sharpener
that is expected to last for 6 years for $18. GAAP say that the pencil sharpener, because it is
expected to last for 6 years, should be listed as an asset and depreciated—or charged off—
▪ Faithful Representation – information accurately depicts what really happened.
To provide a faithful representation, information must be:
TEACHING TIP
Financial statements must present faithful representation to be of value. The SEC requires
firms listed on an organized exchange to have financial statements audited by a Certified
▪ Enhancing Qualities
o Comparability—when different companies use the same accounting
principles. To make a comparison, companies must disclose the accounting
methods used.
2-10
o Consistency—when a company uses the same accounting principles and
methods from year to year
o Verifiable—information that is proven to be free from error.
TEACHING TIP
Firms must follow prescribed accounting principles if users are to compare financial
statements.
Consistency requires firms to be consistent in the accounting principles used. However, if
Assumptions and Principles in Financial Reporting—To develop accounting
standards, the FASB relies on the following key assumptions and principles:
TEACHING TIP
An example of a transaction expressed in terms of money would be the purchase of a
building, paying the rent for the month, or paying the payroll. On the other hand, hiring an
▪ Economic Entity Assumption
o Every economic entity can be separately identified and accounted for.
o Economic events can be identified with a particular unit of accountability.
TEACHING TIP
Explain to students that if they owned a bicycle shop in a nearby community, the economic
transactions of the business would be kept separate from the students’ personal transactions.
2-11
TEACHING TIP
Financial statements may be prepared monthly, quarterly, or annually, depending on the
needs of the business.
▪ Going Concern Assumption—Assumes the business will remain in operation for
the foreseeable future
TEACHING TIP
Use this topic as a way to discuss some of the decisions the CPA must make about risk.
What would be some of the factors that the CPA as an auditor would look for to support the
going concern assumption?
Principles in Financial Reporting
▪ Measurement Principles—GAAP generally uses one of two measurement
principles: the cost principle or the fair value principle
TEACHING TIP
Ask students to assume they just bought a delivery van for their business. The van had a
Cost Constraint—Determining whether the cost that companies will incur to provide the
information will outweigh the benefit that financial statement users will gain from having
the information available.
IFRS
A Look at IFRS
The classified balance sheet, although generally required internationally, contains certain
variations 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 statement of financial position information in this order:
o Noncurrent assets
o Current assets
o Equity
o Noncurrent liabilities
o 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.
▪ 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 prepared 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
2-13
▪ 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).
LOOKING TO THE FUTURE
The IASB and the FASB are working on a project to converge their standards related to
financial statement presentation. A key feature of the proposed framework is that each of the
statements 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 position would also be used in the income statement and the statement of cash flows.
2-14
Chapter 2 Review
Identify sections of a classified balance sheet. Explain the differences between current and
long-term assets and liabilities. Identify accounts that fit into each section.
What is measured by profitability ratios? Compute EPS and discuss how it is used to measure
profitability.
What is the relationship between a retained earnings statement and a statement of stockholders’
equity? Which contains the most information?
Define liquidity and solvency. Identify and compute ratios for analyzing a firm’s liquidity and
solvency. How are these ratios interpreted?
Use the statement of cash flows to evaluate solvency. Compute free cash flow and describe
what it measures.