Chapter 2
Financial Statements and
the Annual Report
After studying this chapter, students should be able to:
◼ Describe the objectives of financial reporting. (Module 1–LO1).
◼ Describe the qualitative characteristics of accounting information. (Module 1–LO2).
◼ Explain the concept and purpose of a classified balance sheet and prepare the statement. (Module
2–LO3).
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Chapter Outline
MODULE 1 FINANCIAL REPORTING OBJECTIVES AND
CHARACTERISTICS OF USEFUL INFORMATION
Module 1
LO 1
Financial Reporting Objectives and Characteristics of Useful
Information
Financial reporting has one overriding objective: to provide useful information to those who must make
financial decisions.
◼ To external users, the financial statements and the notes and other information found in the annual
report are the key sources of information needed to make their business decisions.
◼ In preparing the financial statements, accountants must consider:
⚫ The objectives of financial reporting.
⚫ The characteristics that make accounting information useful.
◼ The overall objective of financial reporting is to provide financial information to permit external
users of the information to make informed decisions on whether to provide resources to the
company.
⚫ Users include management of a company (internal users) and others not involved in the daily
operations of the business (external users).
⚫ External users make their decisions based on general-purpose financial statements prepared
by management.
◼ The purpose of financial reporting is to help the users reach their decision in an informed manner.
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When and if the loan will be repaid.
⚫ The company needs information on its own prospective cash flows.
Module 1
LO 2
What Makes Accounting Information Useful? Qualitative
Characteristics
Qualitative (i.e., non-numerical) characteristics that make accounting information useful (EXAMPLE 2–2
summarizes these characteristics):
Understandability
◼ Understandability: the quality of accounting information that makes it comprehensible to those
Relevance
◼ Relevance: the capacity of information to make a difference in a decision.
⚫ Predictive value – help determine if a decision should be made.
⚫ Confirming value – confirm that the right decision was made.
Faithful Representation
Comparability and Consistency
◼ Comparability: for accounting information, the quality that allows a user to analyze two or more
companies and look for similarities and differences.
⚫ Not necessarily uniformity – alternative methods are acceptable under GAAP.
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Materiality
◼ Materiality: the magnitude of an accounting information omission or misstatement that will affect
the judgment of someone relying on the information.
Conservatism
◼ Conservatism: the practice of using the least optimistic estimate when two estimates of amounts
are about equally likely.
An International Perspective on Qualitative Characteristics
◼ The International Accounting Standards Board (IASB) has the same objectives and qualitative
characteristics of financial reporting as the FASB.
MODULE 2 CLASSIFIED BALANCE SHEETS
Module 2
LO 3
Classified Balance Sheets
Understanding the Operating Cycle
Current Assets
The basic distinction on a classified balance sheet is between current and noncurrent items (EXAMPLE 2–4
is an example of a classified balance sheet).
CHAPTER 2 FINANCIAL STATEMENTS AND THE ANNUAL REPORT
◼ Cash, accounts receivable, and inventory are current assets because they are cash or will be
realized in (converted to) cash within one year.
Noncurrent Assets
Noncurrent assets (also called long-term assets) are any assets not meeting the definition of a current asset.
Noncurrent assets include:
◼ Investments:
⚫ Securities not expected to be sold within the next year.
◼ Property, Plant, and Equipment: tangible, productive assets used in the operations of a business
rather than held for resale.
⚫ The distinction between inventory and equipment depends on the company’s intent when
acquiring the asset.
◼ Intangible assets: provide benefits to the firm over the long-term.
⚫ They lack physical substance.
Current Liabilities
Current liabilities are obligations that will be satisfied within the next operating cycle or one year, if the
cycle is shorter than one year.
◼ The classification of a note payable depends on its maturity date.
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Long-Term Liabilities
Long-term liabilities are any obligations that will not be paid within the next year or the operating cycle,
whichever is longer.
Stockholders’ Equity
Stockholders’ equity represents owners’ claims on the assets of the business that arise from contributed
capital and earned capital.
◼ Capital stock indicates the owners’ investment in the business.
⚫ Common stock – the most basic form of ownership.
Module 2
LO 4
Using a Classified Balance Sheet: Introduction to Ratios
A company’s ability to pay its debts as they come due can be measured by computing the working capital
and current ratio.
Working Capital
◼ Liquidity is the ability of a company to pay its debts as they come due.
Current Ratio
◼ Working capital is limited in its informational values because it is an absolute dollar amount.
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⚫ In general, the higher the current ratio, the more liquid the company.
⚫ General rule of thumb 2:1 current ratio is good. Also depends on industry company is in.
MODULE 3 INCOME STATEMENTS, STATEMENTS OF
RETAINED EARNINGS, AND STATEMENTS OF CASH
FLOWS
Module 3
LO 5
The income statement summarizes the results of operations for a period of time. All companies prepare
What Appears on the Income Statement?
◼ The income statement reports the excess of revenues over expenses –the net income of the period.
Or in the event of an excess of expenses over revenues, the income statement reports the net loss
for the period.
Format of the Income Statement
Corporations use one of two formats to prepare the income statement. Both forms are generally accepted,
although more companies use the multiple-step format.
◼ Single-step: all expenses and losses are added together and deducted in a single step from the sum
of all revenues and gains to arrive at net income. (Example 2-6)
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Operating expenses are further subdivided into selling expenses and general and
administrative expenses.
Module 3
LO 6
Using an Income Statement
The income statement can be used to evaluate the profitability of a business.
◼ Profit margin: Net income ÷ Sales.
⚫ If the profit margin is high, generally means that the company is generating revenue but that it
Module 3
LO 7
The Statement of Retained Earnings
The statement of stockholders’ equity explains the changes in the components of owners’ equity during
the period. (EXAMPLE 2-9)
◼ Retained earnings and capital stock are the two primary components of stockholders’ equity.
Module 3
LO 8
The Statement of Cash Flows
All publicly held corporations are required to present the statement of cash flows in their annual
reports. (Example 2-10)
◼ The statement of cash flows summarizes a company’s operating, investing, and financing activities
for the period. Each of these categories can result in a net inflow or net outflow of cash.
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MODULE 4 READING AND USING THE ANNUAL REPORT
Module 4
LO 9
Reading and Using the Annual Report
Panera Bread’s Balance Sheet (EXHIBIT 2-1)
◼ Consolidated financial statements – reflect the position and results of all operations that are
controlled by a single entity.
Panera Bread’s Income Statement (EXHIBIT 2-2)
◼ Multiple-step income statements for a three-year period are presented.
Making Business Decisions
The Current Ratio
◼ Ratio Analysis Model: used to determine the company’s liquidity.
⚫ Formulate the Question: How liquid is Panera Bread?
⚫ Gather the Information from the Financial Statements: Current ratios and current liabilities
can be found on the balance sheet.
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◼ Business Decision Model:
⚫ Formulate the Question: Should a banker loan money to Panera Bread?
⚫ Gather Information from the Financial Statements and Other Sources: This information will
come from a variety of sources, not limited to, but including the following:
The balance sheet, income statement, and statement of cash flows.
⚫ Analyze the Information Gathered:
Compare Panera Bread’s current ratio with Chipotle’s as well as with industry averages.
Look at trends over time in the current ratios.
The Profit Margin
◼ Ratio Analysis Model: used to determine the company’s profitability.
⚫ Formulate the Question: How profitable is Panera Bread?
⚫ Gather the Information from the Financial Statements: Net income and net sales or revenues
can be found on the income statement.
◼ Business Decision Model:
⚫ Formulate the Question: If you were an investor, would you buy stock in Panera Bread?
CHAPTER 2 FINANCIAL STATEMENTS AND THE ANNUAL REPORT
⚫ Analyze the Information Gathered:
Compare Panera Bread’s profit margin with Chipotle’s as well as with industry averages.
Look at trends over time in the profit margins.
Review projections for economic outlook.
Other Elements of an Annual Report
◼ Privately held companies tend to distribute only financial statements, without the additional
information normally included in the annual reports of public companies.
◼ Although the formats of annual reports vary, certain basic elements have become standard in the
annual reports of publicly held companies:
◼ Report of Independent Accountants (Auditors’ Report) (Exhibit 2-3).
⚫ The opinion rendered by a public accounting firm concerning the fairness of the presentation
of the financial statements.
◼ Ethical responsibility of management and auditors to stockholders.
⚫ Stockholders need assurances that the financial statements are a fair representation of the
company’s operations and financial position.
⚫ Management and auditors have an ethical responsibility to the shareholders.