INSTRUCTOR’S MANUAL
2-12
⚫ Gives management opportunity to provide insights into future trends.
CHAPTER 2 FINANCIAL STATEMENTS AND THE ANNUAL REPORT
2-13
Lecture Suggestions
Module 1
LO 1
Where can external users obtain financial information about a company? Discuss the
convenience, for both the user and the company, of having standard, published financial
Module 1
LO 2
These characteristics are fundamental to all future topics, so a brief discussion of each one
is useful. The following is one approach (The balance sheet for Dixon Sporting Goods is
illustrated in Example 2-4):
• Understandability: Are the Dixon Sporting Goods statements written in clear, concise
language?
Module 2
LO 3
Have students list as many businesses as they can to fit into each type of business: service,
merchandiser, and manufacturer. Encourage them to think about small, local businesses, not
just big corporations. Then, ask them to discuss types of assets and liabilities that could be
found in these businesses and classify as current or noncurrent. Ask them to estimate the
operating cycle for each type of business. Are some assets and liabilities common to all
types of businesses?
Have students review a classified balance sheet and identify the subtotals presented.
Practice comparing components of a balance sheet from year to year to get an idea of
trends.
Identify the important subtotals presented on a multiple-step income statement and their
importance to income statement analysis. Which format do students prefer and why? Can
you determine the gross profit from a single-step income statement?
statements, instead of responding to requests for information as they come in. Also, discuss
INSTRUCTOR’S MANUAL
2-14
Module 3
LO 6
Students have calculated a number of ratios, and will try to memorize all of them in
anticipation of an exam. Point out that for most of the ratios the calculation is obvious.
Once you know what gross profit is, what else could the gross profit ratio be but the ratio of
Module 3
LO 7
How does the statement of retained earnings link the income statement and the balance
sheet? What causes owners’ equity to increase? What causes owners’ equity to decrease?
Would a net loss cause owners’ equity to increase or decrease?
Module 3
LO 8
Discuss the difference between a cash inflow and a cash outflow, with examples of each.
CHAPTER 2 FINANCIAL STATEMENTS AND THE ANNUAL REPORT
2-15
Projects and Activities
Module 1
LO 2
What Makes Accounting Information Useful? Qualitative
Characteristics
In-class discussion: How understandable are the financial statements of Dixon Sporting Goods?
You have been introduced in these opening chapters to the concept of presenting financial data in the form
of organized statements, and have not learned much detail about how and why items find their way into
these statements. You have, however, had the opportunity to look at the reports of more than one large
corporation. Examine the income statement, balance sheet, and statement of cash flows of Dixon Sporting
Goods.
◼ Team presentation: Work together with four or five classmates to prepare a presentation for your
class to explain the Dixon Sporting Goods financial statements: the income statement, the balance
sheet, the statement of retained earnings, and the statement of cash flows, or the equivalents of
these for Dixon Sporting Goods. Explain what each line item is.
◼ Do the statements, taken as a whole, fulfill the goal of understandability as set out by the FASB?
Review the definition of “understandability” given in this chapter.
Solution
◼ Students once again look closely at a set of financial statements. They will find the Dixon Sporting
Goods statements reasonably straightforward and probably understandable by most people since
revenues, costs and expenses, cash, and supplies are all nearly every day terms. However, make
INSTRUCTOR’S MANUAL
2-16
In-class discussion: Asset valuation
Look at Dixon Sporting Goods balance sheet, and consider the total listed for Property, Plant and
Equipment, of $219,400.
◼ What, physically, might this number represent?
◼ Could they sell these assets for $219,400? Is it what they paid for them?
Solution
◼ These are tangible, productive assets used in the operation of Dixon’s business. Land and
buildings are self-explanatory. Store furniture and fixtures could include the sales registers and
shelving, etc to place their products. It would not include anything that would be sold to
In-class discussion: Materiality
All businesses are subject to various types of legal proceedings. Merck & Co. Inc., a global health care
company that manufacturers prescription medicines, has been a defendant in a number of product liability
lawsuits. In the notes to Merck’s 2014 financial statements, the company states:
1 Merck & Co., Inc., December 31, 2014 10-K, p. 106.
2Merck & Co., Inc., December 31, 2012 10-K, p.115-116.
CHAPTER 2 FINANCIAL STATEMENTS AND THE ANNUAL REPORT
2-17
Solution
An item with material effect would influence the decision of an informed reader of the financial statements.
INSTRUCTOR’S MANUAL
2-18
Module 3
LO 6
Using an Income Statement
Outside assignment: Whose statement?
It is often possible to tell a lot about a company by looking at one or more of their financial statements,
without knowing anything else about them. Carefully look over the following financial statement from an
actual company.
XXX Corporation3
Consolidated Statement of Operations
Year Ended December 31, XXXX
($ millions)
OPERATING REVENUES:
Passenger $ 17,658
Freight 175
Other 772
Other operating expenses 2,205
Total operating expenses 16,380
OPERATING INCOME 2,225
OTHER EXPENSES (INCOME):
Interest expense 130
Capitalized interest (23)
Interest income (7)
Other (gains) losses, net 309
Total other expenses (income) 409
CHAPTER 2 FINANCIAL STATEMENTS AND THE ANNUAL REPORT
Solution
◼ The statement is the income statement. The statement of operations is an equally acceptable title
for it, reflecting what the statement is – a summary of the company’s operations for the year cited.
Other Elements of an Annual Report
Outside assignment: Annual reports
Have students pick a company and obtain their annual report online. Look at the Management’s Discussion
and Analysis. In your own words, what is management’s outlook for the future? What are their major
strengths and weaknesses?
Food for thought: Auditor obligations
An article in The Wall Street Journal said that the auditors for Wiz Technology resigned in a dispute over
the company’s accounting for executive salaries. Even though the article was published many years ago,
the issues are timeless especially in light of the current accounting scandals. The article said,
Explain why, in your opinion, the auditors felt compelled to resign.
Solution
Auditors certify that the statements are prepared in accordance with generally accepted accounting
principles, consistently applied. If this was not the case, and if the company did not agree to an acceptable
INSTRUCTOR’S MANUAL
2-20
audit qualification in the auditors’ opinion, the auditors could only choose between rendering an opinion
that they did not believe to be true, or resigning to avoid rendering any opinion.
Ethical decision: Auditor’s report
As a member of a small CPA firm, you have been asked to review the December 31 year-end financial
statements of a small ($2 million revenue) company in an East Coast city. The company has applied for a
long-term loan from the bank. You are interested to note as you begin your review of the company’s
records that a principal stockholder is your former college roommate. You are preparing your report and
wonder about the following items:
◼ The company decided during the last month of the year to change their method of accounting for
depreciation for this year’s financial statements. You do not believe that any adjustments were
made to prior years’ reported results as a consequence of this change.
Should these items be disclosed in your report? Why or why not? If you disclose, how should your
disclosure be phrased? Should you disclose any other facts to the company, to your employer, or in your
report? Should the audit have been conducted differently? In your answers, try to keep in mind some of the
fundamental qualitative principles underlying financial reporting and cite them where relevant.
Solution
First, you probably should have stopped and called in another member of the firm to do the review the
moment you discovered the identity of the principal stockholder. Even if you have no ongoing relationship
with your former roommate (and no indication is given one way or the other), it is always prudent to avoid
even the appearance of impartiality or a conflict of interest.
CHAPTER 2 FINANCIAL STATEMENTS AND THE ANNUAL REPORT
2-21
claiming it will not be a problem. The bank wants to be sure their loan will be repaid. The
departure of a customer may influence their decision on the loan. They may hear about it from
another source. The company will make a more positive impression if it discloses and explains the
Decision
Models
Using Decision Models
Outside assignment: Grizzly, Inc. Current ratio, Business Decision Model, and Ratio Analysis Model
Assume that you are a lending officer for a large bank. The management of Grizzly Inc. has come to you
asking for a loan. They have provided you with their Income Statement and Balance Sheet as of December
31, 2016. (Note: this information is located in the solution to the review problem).
Required:
One of the first steps you undertake is to determine Grizzly’s liquidity. Use the five steps in the ratio
analysis model to analyze the current ratio.
As a loan officer, you must consider a variety of factors, including financial ratios, before making the loan.
Use the Business Decision Model to decide if the bank should make a loan offer to Grizzly.
Solution: Ratio Analysis Model
1. Formulate the Question. Is Grizzly Inc. liquid enough to pay its obligations as they come
due?
Solution – Business Decision Model
1. Formulate the Question. After considering all relevant information, should I (the bank) loan
money to Grizzly Inc.?
INSTRUCTOR’S MANUAL
2-22
2. Gather Information From the Financial Statements and Other Sources. The information
will come from a variety of sources, including:
a. The balance sheet will provide information about liquidity and the items that make
up current assets and current liabilities.
3. Analyze the Information Gathered.
a. Use the Ratio Decision Model to compute and analyze the liquidity ratios. Analyze
the composition of the current assets to determine how liquid they really are. Can all
of the receivables be collected? Is there any obsolete inventory that can’t be sold?
b. Can we obtain prior year financial statements to see a trend in the ratio?
c. Are there any other liquidity ratios that can be computed?
d. How much long-term debt does the company have? When is this debt due?