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Section B
Understanding Financial
Statements
Handout for Students
Understanding Financial Statements
B-
Copyright © 2018 Pearson Education, Ltd.
2
UNDERSTANDING FINANCIAL STATEMENTS
Maryanne M. Rouse, MBA, CPA
University of South Florida
Financial statements serve as both milestones and signposts. As milestones,
financial statements help the reader assess the past financial performance
and current financial condition of a proprietorship, partnership, or
corporation. As signposts, financial statements provide information about the
past and present that is useful in predicting future financial performance
and condition.
The three most frequently encountered and most widely used financial
statements are the Balance Sheet, the Income Statement, and the Statement of
BASES OF ACCOUNTING
Although there are hybrid systems that combine elements of both, the two most
widely used bases of accounting are the cash basis and the accrual basis.
Cash Basis. Under the cash basis of accounting, revenue is recognized when
cash is received and expenses are recognized when cash is disbursed. Many
small businesses and most individuals use the cash basis of accounting when
Accrual Basis. Under the accrual basis of accounting, revenues are recognized
when they are realized and expenses are matched against revenue.
Realized. Revenue is realized when the earning process is virtually complete
and the amount that will be collected is measurable and reasonably assured.
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Matching. Insures that expenses are recognized in the same period as the
revenue they helped generate.
Monetary Assumption. Only those transactions that can be valued in monetary
terms are recorded in the financial records.
Going Concern Assumption. In the absence of evidence to the contrary, the
Time Period Assumption. Economic activities can be divided into artificial
time periods such as a month, quarter, or year. (The shorter the time period,
Historical Cost. Amounts in the financial records and statements represent
exchange value at the date of acquisition, not current value, or replacement
cost.
Conservatism. When there is doubt concerning which accounting choice is
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
Generally Accepted Accounting Principles (GAAP) is a set of “ground rules”
for valuing, recording, presenting, and disclosing financial information. The
principles set forth in GAAP are intended to (1) help ensure consistency in
the financial statements of a given firm from period to period, and (2)
provide some assurance that the financial statements of one firm can be
compared to those of another.
AUDITED, REVIEWED, COMPILED
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A firm’s management is responsible for the content and preparation of
financial statements; however, the involvement of independent accountants
enhances the credibility of management prepared statements.
When a CPA is involved in compiling management-provided financial data in the
form of a financial report but performs no other procedures, she or he will
provide a Compilation Report. A Compilation Report informs the reader that
ELEMENTS OF FINANCIAL POSITION: THE BALANCE SHEET
The balance sheet provides a “snapshot” of a firm’s financial position.
Prepared at a point in time, the balance sheet shows what the firm owns
(assets) and owes (liabilities owed to outsiders, plus the residual interest
owed to shareholder/owners).
Assets. An asset is something the firm owns that has future economic benefit.
An item cannot be recorded as an asset unless the company owns it. Equipment
leased under a short-term operating lease or a building that is rented would,
Liabilities. Liabilities are obligations to pay, or convey assets in the
future, based on past transactions. Liabilities are divided into current and
Shareholders’ Equity. Shareholders’ equity is the ownership interest of those
who have invested in the company through the purchase of capital stock.
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The Accounting Equation. Assets will always equal liabilities plus
shareholders’ equity. This is not sleight of hand but the result of
A CLOSER LOOK AT THE BALANCE SHEET
ASSETS
Current Assets
Cash. Cash and cash equivalents including currency, bank deposits, and
various marketable securities that can be converted into cash on short
Marketable Securities. Short-term equity and debt investments that are
readily marketable and that the company intends to convert into cash.
Accounts Receivable. Amounts due from customers that have not yet been
collected. Accounts receivable should “turn over” or be collected within the
firm’s normal collection period, usually 30 to 60 days. An increase in the
Inventories. Represents items that have been manufactured or purchased for
Prepaid Expenses/Other Current Assets. Usually minor elements of the balance
Understanding Financial Statements
Non-Current Assets
Property, Plant, and Equipment. Also referred to as “fixed assets,” PP&E
generally includes such long-lived elements as land, buildings, machinery,
Intangibles. Assets with no physical substance but which often have great
economic value. Only those intangibles that have been purchased are shown as
assets. Patents, copyrights, and trademarks are examples of intangibles.
Another important type of intangible asset is goodwill. Goodwill is a label
LIABILITIES
Current Liabilities
Accounts Payable. The amounts the company owes to regular business creditors
Notes Payable. More “formal” liabilities because they are evidenced by a
Accrued Expenses. These represent liabilities for services received but
Income Taxes Payable. Includes unpaid taxes due within 1 year. Many firms use
Other Current Liabilities. Might include warranty obligations and unearned
revenue. If interest payable is a relatively insignificant amount, it may be
Long Term Liabilities
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Deferred Income Taxes. These are created by using different accounting
methods for financial and tax purposes. For example, a company may use
Debentures. Or also called bonds payable are a major source of funds for
large firms. A bond is written evidence of a long-term loan. It is really a
Other Long Term Liabilities. Includes any other amounts owed to creditors
with a due date beyond 1 year.
SHAREHOLDERS’ EQUITY
Preferred Stock. Capital stock with certain preferences as to dividends and
distribution of assets in the event of liquidation. For Serendipity, the
Common Stock. Generally is voting stock with no specified dividend payment;
however, companies may have several classes of common stock, which may
include nonvoting common stock.
Additional Paid-in Capital. Results from selling preferred or common stock at
more than its par value. For example, if 100 shares of $10 par value common
Retained Earnings. A historical record of earnings retained in the business.
It’s important to remember that there is NO CASH in retained earnings.
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Other Items. Treasury stock is the company’s own stock that has been issued,
is fully paid, and has been repurchased by the company. When a company
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Serendipity Manufacturing Co., Inc.
CONSOLIDATED BALANCE SHEET
December 31, 2016 and 2015 (dollars in thousands)
ASSETS
2016
2015
Current Assets
Cash
$ 20,000
$ 15,000
Marketable Securities at market
Property, Plant, & Equipment
Land
$ 30,000
$ 30,000
Buildings
125,000
118,500
Machinery
200,000
171,100
Serendipity Manufacturing Co., Inc.
December 31, 2016 and 2015 (dollars in thousands)
LIABILITIES
2016
2015
Current Liabilities
Accounts Payable
$ 60,000
$ 57,000
Notes payable
SHAREHOLDERS' EQUITY
Preferred Stock, $5.83 cumulative, $100
par value,
authorized, issued, and outstanding, 60,000
shares
$ 6,000
$ 6,000
Common Stock, $5 par value, authorized 20,000,000
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ANALYZING SERENDIPITY’S BALANCE SHEET
Investors, creditors, and other users of financial statements often analyze
relationships between or among balance sheet accounts using ratios. The three
types of ratios used most often are liquidity ratios, leverage ratios, and
activity ratios.
Liquidity Ratios
Liquidity ratios focus on working capital accounts and provide information
Current Ratio. Current assets divided by current liabilities. It tells how
many dollars of current assets are available to cover each dollar of current
liabilities. For Serendipity, the current ratio for 2016 was
Quick Ratio. This is “quick” assets (current assets minus inventories,
prepayments, and other current assets) divided by current liabilities. Also
Cash Ratio. This is cash divided by current liabilities. The cash ratio shows
Leverage Ratios
Leverage ratios provide information about the relationship between the
Debt to Equity Ratio. The total liabilities divided by total shareholder’s
equity. Serendipity’s debt to equity ratio for 2016 is $316,000/$346,000 or
