CHAPTER 2
A Further Look at Financial Statements
Learning Objectives
1. Identify the sections of a classified balance sheet.
2. Use ratios to evaluate a company’s profitability, liquidity, and solvency.
3. Discuss financial reporting concepts.
Summary of Questions by Learning Objectives and Bloom’s Taxonomy
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Questions
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Brief Exercises
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Do It! Exercises
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1b.
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Exercises
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Problems: Set A
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ASSIGNMENT CHARACTERISTICS TABLE
Problem
Number
Description
Difficulty
Level
Time
Allotted (min.)
1A
Prepare a classified balance sheet.
Simple
10–20
2A
Prepare financial statements.
Moderate
20–30
3A
Prepare financial statements.
Moderate
20–30
4A
Compute ratios; comment on relative profitability,
liquidity, and solvency.
Moderate
20–30
5A
Compute and interpret liquidity, solvency, and profitability
ratios.
Simple
10–20
6A
Compute and interpret liquidity, solvency, and profit–
ability ratios.
Moderate
15–25
7A
Compute ratios and compare liquidity, solvency, and
profitability for two companies.
Moderate
15–25
8A
Comment on the objectives and qualitative characteristics
of financial reporting.
Simple
10–20
ANSWERS TO QUESTIONS
1. A company’s operating cycle is the average time that is required to go from cash to cash in prod–
ucing revenue.
LO 1 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Measurement
2. Current assets are assets that a company expects to convert to cash or use up within one year of
the balance sheet date or the company’s operating cycle, whichever is longer. Current assets are
listed in the order in which they are expected to be converted into cash.
LO 1 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Reporting
3. Long-term investments are investments in stocks and bonds of other companies where the
conversion into cash is not expected within one year or the operating cycle, whichever is longer
and plant assets not currently in operational use. Property, plant, and equipment are tangible
resources of a relatively permanent nature that are being used in the business and not intended
for sale.
LO 1 BT: C Diff: M TOT: 2 min. AACSB: None AICPA FC: Reporting
4. Current liabilities are obligations that will be paid within the coming year or operating cycle,
whichever is longer. Long-term liabilities are obligations that will be paid after one year.
LO 1 BT: C Diff: M TOT: 1 min. AACSB: None AICPA FC: Reporting
5. The two parts of stockholders’ equity and the purpose of each are: (1) Common stock is used to
record investments of assets in the business by the owners (stockholders). (2) Retained earnings
is used to record net income retained in the business.
LO 1 BT: K Diff: M TOT: 2 min. AACSB: None AICPA FC: Reporting
6. (a) Geena is not correct. There are three characteristics: liquidity, profitability, and solvency.
(b) The three parties are not primarily interested in the same characteristics of a company.
Short-term creditors are primarily interested in the liquidity of the company. In contrast,
long-term creditors and stockholders are primarily interested in the profitability and
solvency of the company.
LO 2 BT: C Diff: M TOT: 3 min. AACSB: None AICPA FC: Reporting
7. (a) Liquidity ratios: Working capital and current ratio.
(b) Solvency ratios: Debt to assets and free cash flow.
(c) Profitability ratio: Earnings per share.
LO 2 BT: K Diff: E TOT: 2 min. AACSB: None AICPA FC: Reporting
8. Debt financing is riskier 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 assets
financed by debt, the riskier the company.
LO 2 BT: C Diff: E TOT: 2 min. AACSB: None AICPA FC: Reporting
9. (a) Liquidity ratios measure the short-term ability of the company to pay its maturing obligations
and to meet unexpected needs for cash.
(b) Profitability ratios measure the income or operating success of a company for a given period
of time.
(c) Solvency ratios measure the company’s ability to survive over a long period of time.
LO 2 BT: K Diff: E TOT: 2 min. AACSB: None AICPA FC: Reporting
10. (a) The increase in earnings per share is good news because it means that profitability has improved.
(b) An increase in the current ratio signals good news because the company improved its ability
to meet maturing short-term obligations.
(c) The increase in the debt to assets ratio is bad news because it means that the company has
increased its obligations to creditors and has lowered its equity “buffer.”
(d) A decrease in free cash flow is bad news because it means that the company has become
less solvent. The higher the free cash flow, the more solvent the company.
LO 2 BT: AN Diff: M TOT: 3 min. AACSB: Analytic AICPA FC: Reporting
11. (a) The debt to assets ratio and free cash flow indicate the company’s ability to repay the face
value of the debt at maturity and make periodic interest payments.
(b) The current ratio and working capital indicate a company’s liquidity and short-term debt-
paying ability.
(c) Earnings per share indicates the earning power (profitability) of an investment.
LO 2 BT: C Diff: M TOT: 3 min. AACSB: Analytic AICPA FC: Reporting
12. (a) Generally accepted accounting principles (GAAP) are a set of rules and practices, having
substantial support, that are recognized as a general guide for financial reporting purposes.
(b) The body that provides authoritative support for GAAP is the Financial Accounting Standards
Board (FASB).
LO 3 BT: K Diff: E TOT: 2 min. AACSB: None AICPA FC: Measurement
13. (a) The primary objective of financial reporting is to provide information useful for decision making.
(b) The fundamental qualitative characteristics are relevance and faithful representation. The
enhancing qualities are comparability, consistency, verifiability, timeliness, and
understandability.
LO 3 BT: K Diff: M TOT: 2 min. AACSB: None AICPA FC: Measurement
14. Dietz is correct. Consistency means using the same accounting principles and accounting
methods from period to period within a company. Without consistency in the application of
accounting principles, it is difficult to determine whether a company is better off, worse off, or the
same from period to period.
LO 3 BT: AN Diff: M TOT: 2 min. AACSB: Analytic AICPA FC: Measurement and Reporting
15. Comparability results when different companies use the same accounting principles. Consistency
means using the same accounting principles and methods from year to year within the same
company.
LO 3 BT: C Diff: E TOT: 1 min. AACSB: None AICPA FC: Measurement
16. The cost constraint allows accounting standard-setters to weigh the cost that companies will incur
to provide information against the benefit that financial statement users will gain from having the
information available.
LO 3 BT: K Diff: E TOT: 1 min. AACSB: None AICPA FC: Measurement
17. Accounting standards are not uniform because individual countries have separate standard-
setting bodies. Currently many non-U.S. countries are choosing to adopt International Financial
Reporting Standards (IFRS). It appears that accounting standards in the United States will move
toward compliance with IFRS.
LO 3 BT: C Diff: M TOT: 2 min. AACSB: None AICPA FC: Measurement
18. Accounting relies primarily on two measurement principles. Fair value is sometimes used when
market price information is readily available. However, in many situations reliable market price
information is not available. In these instances, accounting relies on historical cost as its basis.
19. The economic entity assumption states that every economic entity can be separately identified and
accounted for. This assumption requires that the activities of the entity be kept separate and distinct
from (1) the activities of its owners (the shareholders) and (2) all other economic entities. A
shareholder of a company charging personal living costs as expenses of the company is an
example of a violation of the economic entity assumption.
20. At September 27, 2014 Apple’s largest current asset was Cash and cash equivalents of $14,557
million, its largest current liability is Accounts payable of $16,459 million and its largest item
under “Assets” was Property and equipment, net of $16,967 million.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 2-1
CL Accounts payable CL Income taxes payable
BRIEF EXERCISE 2-2
CHIN COMPANY
Partial Balance Sheet
Current assets
BRIEF EXERCISE 2-3
Earnings per share =
Net income Preferred dividends
Average common shares outstanding
—
BRIEF EXERCISE 2-4
Working capital = Current assets – Current liabilities
Current assets ($102,500,000
Current ratio:
Current assets
$102,500,000
BRIEF EXERCISE 2-5
(a) Current ratio
$262,787
(b) Debt to assets
$376,002
(c) Free cash flow
$62,300 – $24,787 – $12,000 = $25,513
BRIEF EXERCISE 2-6
(a) True.
BRIEF EXERCISE 2-7
(a) Predictive value.
(b) Confirmatory value.
BRIEF EXERCISE 2-8
(a) Relevant.
BRIEF EXERCISE 2-9
(a) 1. Predictive value.
BRIEF EXERCISE 2-10
(c)
SOLUTIONS TO DO IT! EXERCISES
DO IT! 2-1a
MYLAR CORPORATION
Balance Sheet (partial)
December 31, 2017
Assets
Current assets
Cash ………………………………………………………….. $ 13,000
Accounts receivable ………………………………….. 22,000
LO 1 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
DO IT! 2-1b
IA
Trademarks
CA
Inventory
CL
Notes payable (current)
PPE
Accumulated depreciation
Interest revenue
PPE
CL
Income taxes payable
Common stock
LTI
Debt investments (long-term)
NA
Advertising expense
CL
Unearned sales revenue
LTL
Mortgage payable (due in 3 years)
DO IT! 2-2
(a)
2017
2016
(40,000 + 75,000)/2
Nguoi’s profitability, as measured by the amount of income available for
each share of common stock, increased by 33 percent (($1.29 –
(b) 2017 2016
Current ratio
$54,000
= 2.45:1
$36,000
= 1.20:1
$22,000
$30,000
$72,000
= 30%
$100,000
= 49%
$240,000
$205,000
(c)
Free cash flow 2017: $90,000 – $6,000 – $3,000 – $27,000 = $54,000
DO IT! 2-3
2. Faithful representation
4. Cost constraint
6. Historical cost principle
8. Periodicity assumption
10. Materiality
12. Comparability
SOLUTIONS TO EXERCISES
EXERCISE 2-1
CL
Accounts payable
CA
Inventory
CA
Accounts receivable
CA
Stock investments
PPE
PPE
Land (in use)
PPE
Buildings
LTL
Mortgage payable
CA
Cash
CA
Supplies
CL
PPE
Equipment
CA
Prepaid rent
EXERCISE 2-2
CA
Prepaid advertising
IA
Patents
PPE
Equipment
LTL
Bonds payable
Common stock
Salaries and wages payable
PPE
Accumulated
Income taxes payable
CA
Accounts receivable
Inventory
LTI
Land (held for future use)
EXERCISE 2-3
THE BOEING COMPANY
Partial Balance Sheet
December 31, 2017
(in millions)
Assets
Current assets
Cash ……………………………………………………………… $ 9,215
Debt investments …………………………………………… 2,008
EXERCISE 2-4
H. J. HEINZ COMPANY
Partial Balance Sheet
April 30, 2017
(in thousands)
Assets
Current assets
Cash …………………………………………… $ 373,145
Accounts receivable ……………………. 1,171,797
EXERCISE 2-5
LONGHORN COMPANY
Balance Sheet
December 31, 2017
Assets
Current assets
Cash …………………………………………….. $11,840
Accounts receivable ……………………… 12,600
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable …………………………. $ 9,500
Current maturity of note payable …….. 13,600
EXERCISE 2-6
TEXAS INSTRUMENTS, INC.
Balance Sheet
December 31, 2017
(in millions)
Assets
Current assets
Cash ………………………………………………………………. $ 1,182
Debt investments …………………………………………….. 1,743
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable ……………………………………………. $1,459
Income taxes payable ………………………………………. 128
Total current liabilities ………………………………. $ 1,587
Long-term liabilities
EXERCISE 2-7
(a) Earnings per share =
Net income Preferred dividends
Average common shares outstanding
−
(b) Using net income (loss) as a basis to evaluate profitability, Callaway
Golf’s income improved by 21% [($66,176 – $54,587) ÷ 54,587] between
(c) To determine earnings per share, dividends on preferred stock are
EXERCISE 2-8
(a) FAIRVIEW CORPORATION
Income Statement
For the Year Ended July 31, 2017
Revenues
Service revenue ……………………………………… $66,100
FAIRVIEW CORPORATION
Retained Earnings Statement
For the Year Ended July 31, 2017
Retained earnings, August 1, 2013 …………………. $34,000
Less: Net loss ……………………………………………… $2,500
(b) FAIRVIEW CORPORATION
Balance Sheet
July 31, 2017
Assets
Current assets
Cash ………………………………………………………. $29,200
EXERCISE 2-8 (Continued)
(b) FAIRVIEW CORPORATION
Balance Sheet (Continued)
July 31, 2017
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable ……………………………………… $ 4,100
Salaries and wages payable ………………………. 2,080
(c)
$38,980
Current ratio = = 6.3:1
$6,180
(d) The current ratio would not change because equipment is not a current
asset and a 5-year note payable is a long-term liability rather than a
current liability.
The debt to assets ratio would increase from 15.5% to 39.1%*.
EXERCISE 2-8 (Continued)
I would also consider making the sale but requiring a substantial down-
payment and smaller note.
EXERCISE 2-9
(a)
Beginning of Year
End of Year
Working capital
(b) Nordstrom’s liquidity decreased slightly during the year. Its current
(c) Nordstrom’s current ratio at both the beginning and the end of the
recent year exceeds Best Buy’s current ratio for 2014 (and 2013).
EXERCISE 2-10
(a)
Current ratio = $60,000
$30,000 = 2.0: 1