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Chapter 5
Communicating and InterpretingAccounting Information
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-2Players in the Accounting
Communication Process
An An unqualifiedunqualified opinion states opinion states that the financial statements are that the financial statements are fair presentations in all material fair presentations in all material
respects in conformity with respects in conformity with GAAP.GAAP.
An An unqualifiedunqualified opinion states opinion states that the financial statements are that the financial statements are fair presentations in all material fair presentations in all material
respects in conformity with respects in conformity with GAAP.GAAP.
Independent AuditorsIndependent AuditorsVerificationVerification
Partners, Managers, StaffPartners, Managers, StaffGuided by GAASGuided by GAAS
Independent AuditorsIndependent AuditorsVerificationVerification
Partners, Managers, StaffPartners, Managers, StaffGuided by GAASGuided by GAAS
ManagementManagementPreparationPreparation
CEO, CFO, Accounting StaffCEO, CFO, Accounting StaffGuided by GAAPGuided by GAAP
ManagementManagementPreparationPreparation
CEO, CFO, Accounting StaffCEO, CFO, Accounting StaffGuided by GAAPGuided by GAAP
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-3
Information Information IntermediariesIntermediaries
Analysis and AdviceAnalysis and AdviceFinancial analysis, Financial analysis,
Information servicesInformation services
Information Information IntermediariesIntermediaries
Analysis and AdviceAnalysis and AdviceFinancial analysis, Financial analysis,
Information servicesInformation services
Financial analysts Financial analysts make predictions make predictions
concerning concerning companies’ future companies’ future earnings and stock earnings and stock
prices.prices.
Financial analysts Financial analysts make predictions make predictions
concerning concerning companies’ future companies’ future earnings and stock earnings and stock
prices.prices.
Players in the Accounting
Communication Process
Independent AuditorsIndependent AuditorsVerificationVerification
Partners, Managers, StaffPartners, Managers, StaffGuided by GAASGuided by GAAS
Independent AuditorsIndependent AuditorsVerificationVerification
Partners, Managers, StaffPartners, Managers, StaffGuided by GAASGuided by GAAS
ManagementManagementPreparationPreparation
CFO, CEO, Accounting StaffCFO, CEO, Accounting StaffGuided by GAAPGuided by GAAP
ManagementManagementPreparationPreparation
CFO, CEO, Accounting StaffCFO, CEO, Accounting StaffGuided by GAAPGuided by GAAP
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-4
Information Information IntermediariesIntermediaries
Analysis and AdviceAnalysis and AdviceFinancial analysis, Financial analysis,
Information servicesInformation services
Information Information IntermediariesIntermediaries
Analysis and AdviceAnalysis and AdviceFinancial analysis, Financial analysis,
Information servicesInformation services
Financial analysts Financial analysts make predictions make predictions
concerning concerning companies’ future companies’ future earnings and stock earnings and stock
prices.prices.
Financial analysts Financial analysts make predictions make predictions
concerning concerning companies’ future companies’ future earnings and stock earnings and stock
prices.prices.
Players in the Accounting
Communication Process
Independent AuditorsIndependent AuditorsVerificationVerification
Partners, Managers, StaffPartners, Managers, StaffGuided by GAASGuided by GAAS
Independent AuditorsIndependent AuditorsVerificationVerification
Partners, Managers, StaffPartners, Managers, StaffGuided by GAASGuided by GAAS
ManagementManagementPreparationPreparation
CFO, CEO, Accounting StaffCFO, CEO, Accounting StaffGuided by GAAPGuided by GAAP
ManagementManagementPreparationPreparation
CFO, CEO, Accounting StaffCFO, CEO, Accounting StaffGuided by GAAPGuided by GAAP
Web Info Services:Web Info Services:www/sec/govwww/sec/gov
www.compustat.comwww.compustat.comwww.djnr.comwww.djnr.com
www.bloomberg.comwww.bloomberg.comwww.firstcall.comwww.firstcall.comwww.hoover.comwww.hoover.com
Web Info Services:Web Info Services:www/sec/govwww/sec/gov
www.compustat.comwww.compustat.comwww.djnr.comwww.djnr.com
www.bloomberg.comwww.bloomberg.comwww.firstcall.comwww.firstcall.comwww.hoover.comwww.hoover.com
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-5
Government Government RegulatorsRegulatorsVerificationVerification
SEC MembersSEC MembersGuided by SEC regs.Guided by SEC regs.
Government Government RegulatorsRegulatorsVerificationVerification
SEC MembersSEC MembersGuided by SEC regs.Guided by SEC regs.
UsersUsersAnalysis and DecisionAnalysis and Decision
Investors, Lenders, etc.Investors, Lenders, etc.
UsersUsersAnalysis and DecisionAnalysis and Decision
Investors, Lenders, etc.Investors, Lenders, etc. Public companies only
ManagementManagementPreparationPreparation
CFO, CEO, Accounting StaffCFO, CEO, Accounting StaffGuided by GAAPGuided by GAAP
ManagementManagementPreparationPreparation
CFO, CEO, Accounting StaffCFO, CEO, Accounting StaffGuided by GAAPGuided by GAAP
Players in the Accounting
Communication Process
Information Information IntermediariesIntermediaries
Analysis and AdviceAnalysis and AdviceFinancial analysis, Financial analysis,
Information servicesInformation services
Information Information IntermediariesIntermediaries
Analysis and AdviceAnalysis and AdviceFinancial analysis, Financial analysis,
Information servicesInformation services
Independent AuditorsIndependent AuditorsVerificationVerification
Partners, Managers, StaffPartners, Managers, StaffGuided by GAASGuided by GAAS
Independent AuditorsIndependent AuditorsVerificationVerification
Partners, Managers, StaffPartners, Managers, StaffGuided by GAASGuided by GAAS
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-6
Guiding Principles for Communicating Useful Information
Primary Objective of External Financial ReportingPrimary Objective of External Financial Reporting To provide economic information to external users To provide economic information to external users
for decision making.for decision making.
Primary Objective of External Financial ReportingPrimary Objective of External Financial Reporting To provide economic information to external users To provide economic information to external users
for decision making.for decision making.
Primary Qualitative CharacteristicsPrimary Qualitative Characteristics
Relevance:Relevance: Timely and Predictive and Feedback ValueTimely and Predictive and Feedback Value
Reliability:Reliability: Accurate, Unbiased, and VerifiableAccurate, Unbiased, and Verifiable
Primary Qualitative CharacteristicsPrimary Qualitative Characteristics
Relevance:Relevance: Timely and Predictive and Feedback ValueTimely and Predictive and Feedback Value
Reliability:Reliability: Accurate, Unbiased, and VerifiableAccurate, Unbiased, and Verifiable
Secondary Qualitative CharacteristicsSecondary Qualitative Characteristics
Comparability:Comparability: Across businessesAcross businesses
Consistency:Consistency: Over timeOver time
Secondary Qualitative CharacteristicsSecondary Qualitative Characteristics
Comparability:Comparability: Across businessesAcross businesses
Consistency:Consistency: Over timeOver time
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-7
Guiding Principles for Communicating Useful Information
Primary Objective of External Financial ReportingPrimary Objective of External Financial Reporting To provide economic information to external users To provide economic information to external users
for decision making.for decision making.
Primary Objective of External Financial ReportingPrimary Objective of External Financial Reporting To provide economic information to external users To provide economic information to external users
for decision making.for decision making.
Primary Qualitative CharacteristicsPrimary Qualitative Characteristics
Relevance:Relevance: Timely and Predictive and Feedback ValueTimely and Predictive and Feedback Value
Reliability:Reliability: Accurate, Unbiased, and VerifiableAccurate, Unbiased, and Verifiable
Primary Qualitative CharacteristicsPrimary Qualitative Characteristics
Relevance:Relevance: Timely and Predictive and Feedback ValueTimely and Predictive and Feedback Value
Reliability:Reliability: Accurate, Unbiased, and VerifiableAccurate, Unbiased, and Verifiable
Secondary Qualitative CharacteristicsSecondary Qualitative Characteristics
Comparability:Comparability: Across businessesAcross businesses
Consistency:Consistency: Over timeOver time
Secondary Qualitative CharacteristicsSecondary Qualitative Characteristics
Comparability:Comparability: Across businessesAcross businesses
Consistency:Consistency: Over timeOver time
The full-disclosure principles requires . . .The full-disclosure principles requires . . .
1.1.A complete set of financial statements,A complete set of financial statements,andand
2.2.Notes to the financial statementsNotes to the financial statements
The full-disclosure principles requires . . .The full-disclosure principles requires . . .
1.1.A complete set of financial statements,A complete set of financial statements,andand
2.2.Notes to the financial statementsNotes to the financial statements
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-8
The Disclosure Process
Press ReleasesPress Releases are used to announce are used to announce quarterly and annual earnings as soon quarterly and annual earnings as soon as the verified figures are available.as the verified figures are available.
Press ReleasesPress Releases are used to announce are used to announce quarterly and annual earnings as soon quarterly and annual earnings as soon as the verified figures are available.as the verified figures are available.
Earnings Press Release Excerpt for Gallaway GolfEarnings Press Release Excerpt for Gallaway Golf
Callaway® Golf
CARLSBAD, Calif./April 25, 2001/ Gallaway Gold Company (NYSE:ELY) today reported record sales for the first quarter ended March 31, 2001. Reported net sales increased 32% to $261.4 million from $197.4 million during the first quarter of 2000. Net income increased . . . . . .
Earnings Press Release Excerpt for Gallaway GolfEarnings Press Release Excerpt for Gallaway Golf
Callaway® Golf
CARLSBAD, Calif./April 25, 2001/ Gallaway Gold Company (NYSE:ELY) today reported record sales for the first quarter ended March 31, 2001. Reported net sales increased 32% to $261.4 million from $197.4 million during the first quarter of 2000. Net income increased . . . . . .
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-9
Annual Reports
For For privatelyprivately held companies, held companies, annual reports are simple annual reports are simple documents that include:documents that include:
1.1. Four basic financial statements.Four basic financial statements.
2.2. Related footnotes.Related footnotes.
3.3. Report of independent Report of independent accountants (auditor’s opinion).accountants (auditor’s opinion).
For For privatelyprivately held companies, held companies, annual reports are simple annual reports are simple documents that include:documents that include:
1.1. Four basic financial statements.Four basic financial statements.
2.2. Related footnotes.Related footnotes.
3.3. Report of independent Report of independent accountants (auditor’s opinion).accountants (auditor’s opinion).
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-10
Annual Reports
For For publicpublic companiescompanies, annual , annual reports are elaborate because of reports are elaborate because of
SEC reporting requirements:SEC reporting requirements:1.1. A Nonfinancial SectionA Nonfinancial Section
A letter to the stockholders, a A letter to the stockholders, a description of management’s description of management’s philosophy, products, successes, etc.philosophy, products, successes, etc.
2.2. A Financial SectionA Financial Section See next slide for a detailed listing . . See next slide for a detailed listing . .
. .
For For publicpublic companiescompanies, annual , annual reports are elaborate because of reports are elaborate because of
SEC reporting requirements:SEC reporting requirements:1.1. A Nonfinancial SectionA Nonfinancial Section
A letter to the stockholders, a A letter to the stockholders, a description of management’s description of management’s philosophy, products, successes, etc.philosophy, products, successes, etc.
2.2. A Financial SectionA Financial Section See next slide for a detailed listing . . See next slide for a detailed listing . .
. .
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-11
Annual Reports - Financial Section
1.1. Summarized financial Summarized financial data for 5- or 10-years.data for 5- or 10-years.
2.2. Management Management Discussion and Discussion and Analysis (Analysis (MD&AMD&A).).
3.3. The four basic financial The four basic financial statements.statements.
4.4. Notes (footnotes).Notes (footnotes).
5.5. Independent Independent Accountant’s Report.Accountant’s Report.
1.1. Summarized financial Summarized financial data for 5- or 10-years.data for 5- or 10-years.
2.2. Management Management Discussion and Discussion and Analysis (Analysis (MD&AMD&A).).
3.3. The four basic financial The four basic financial statements.statements.
4.4. Notes (footnotes).Notes (footnotes).
5.5. Independent Independent Accountant’s Report.Accountant’s Report.
6.6. Recent stock price Recent stock price information.information.
7.7. Summaries of the Summaries of the unaudited quarterly unaudited quarterly financial data.financial data.
8.8. Lists of directors and Lists of directors and officers of the company officers of the company and relevant and relevant addresses.addresses.
6.6. Recent stock price Recent stock price information.information.
7.7. Summaries of the Summaries of the unaudited quarterly unaudited quarterly financial data.financial data.
8.8. Lists of directors and Lists of directors and officers of the company officers of the company and relevant and relevant addresses.addresses.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-12
Quarterly Reports
Usually begin with short letter to Usually begin with short letter to stockholders,stockholders,
Condensed Condensed unauditedunaudited income income statement and balance sheet for the statement and balance sheet for the quarter.quarter.
Often, cash flow statement and Often, cash flow statement and statement of stockholders’ equity are statement of stockholders’ equity are omittedomitted. Some notes to the financial . Some notes to the financial statements also may be omitted.statements also may be omitted.
Usually begin with short letter to Usually begin with short letter to stockholders,stockholders,
Condensed Condensed unauditedunaudited income income statement and balance sheet for the statement and balance sheet for the quarter.quarter.
Often, cash flow statement and Often, cash flow statement and statement of stockholders’ equity are statement of stockholders’ equity are omittedomitted. Some notes to the financial . Some notes to the financial statements also may be omitted.statements also may be omitted.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-13
SEC Reports
Form 10-K Annual ReportForm 10-K Annual Report•Due within 90 days of the fiscal year-endDue within 90 days of the fiscal year-end•Contains audited financial statementsContains audited financial statements
Form 10-K Annual ReportForm 10-K Annual Report•Due within 90 days of the fiscal year-endDue within 90 days of the fiscal year-end•Contains audited financial statementsContains audited financial statements
Form 10-Q Quarterly ReportForm 10-Q Quarterly Report•Due within 45 days of the end of the quarterDue within 45 days of the end of the quarter•Financial statements can be unauditedFinancial statements can be unaudited
Form 10-Q Quarterly ReportForm 10-Q Quarterly Report•Due within 45 days of the end of the quarterDue within 45 days of the end of the quarter•Financial statements can be unauditedFinancial statements can be unaudited
Form 8-K Current ReportForm 8-K Current Report•Due within 15 days of the major event dateDue within 15 days of the major event date•Financial statements can be unauditedFinancial statements can be unaudited
Form 8-K Current ReportForm 8-K Current Report•Due within 15 days of the major event dateDue within 15 days of the major event date•Financial statements can be unauditedFinancial statements can be unaudited
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-14
Financial Statement Formats
Let’s take aLet’s take acloser lookcloser lookat the assetat the asset
section of thesection of thebalance balance sheet!sheet!
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-15
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-16
Current assets Current assets are assets that are assets that
will be turned into will be turned into cash or expire cash or expire (be used up) (be used up)
within the longer within the longer of one year or the of one year or the operating cycle.operating cycle.
Current assets Current assets are assets that are assets that
will be turned into will be turned into cash or expire cash or expire (be used up) (be used up)
within the longer within the longer of one year or the of one year or the operating cycle.operating cycle.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-17
Property, plant and Property, plant and equipment includes equipment includes assets with useful assets with useful lives of more than lives of more than one year acquired one year acquired
for use in the for use in the business rather business rather
than for resale. The than for resale. The amount is reported amount is reported net of net of accumulated accumulated
depreciationdepreciation..
Property, plant and Property, plant and equipment includes equipment includes assets with useful assets with useful lives of more than lives of more than one year acquired one year acquired
for use in the for use in the business rather business rather
than for resale. The than for resale. The amount is reported amount is reported net of net of accumulated accumulated
depreciationdepreciation..
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-18
Intangible assets Intangible assets have no physical have no physical existence and a existence and a long life. They long life. They
include patents, include patents, copyrights, copyrights,
trademarks, etc.trademarks, etc.
Intangible assets Intangible assets have no physical have no physical existence and a existence and a long life. They long life. They
include patents, include patents, copyrights, copyrights,
trademarks, etc.trademarks, etc.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Let’s now look Let’s now look at the liability at the liability section of a section of a classified classified
balance sheet.balance sheet.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-21
Current liabilities Current liabilities are obligations are obligations that will be paid that will be paid
with current with current assets, normally assets, normally within one year.within one year.
Current liabilities Current liabilities are obligations are obligations that will be paid that will be paid
with current with current assets, normally assets, normally within one year.within one year.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-22
Long-term liabilities are debts that have Long-term liabilities are debts that have maturity dates extending beyond one maturity dates extending beyond one
year from the balance sheet date.year from the balance sheet date.
Long-term liabilities are debts that have Long-term liabilities are debts that have maturity dates extending beyond one maturity dates extending beyond one
year from the balance sheet date.year from the balance sheet date.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Finally, we get to the
stockholders’ equity section of a classified balance sheet.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-24
Contributed capital is often shown in Contributed capital is often shown in two separate accounts . . .two separate accounts . . .
1.1. Common stockCommon stock
2.2. Paid-in capitalPaid-in capital
Contributed capital is often shown in Contributed capital is often shown in two separate accounts . . .two separate accounts . . .
1.1. Common stockCommon stock
2.2. Paid-in capitalPaid-in capital
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-25
Comprehensive income includes unrealized Comprehensive income includes unrealized gains/losses on security investments, gains/losses on security investments,
minimum pension liability adjustment, and minimum pension liability adjustment, and foreign currency translation adjustments.foreign currency translation adjustments.
Comprehensive income includes unrealized Comprehensive income includes unrealized gains/losses on security investments, gains/losses on security investments,
minimum pension liability adjustment, and minimum pension liability adjustment, and foreign currency translation adjustments.foreign currency translation adjustments.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-26
Retained earnings is the total Retained earnings is the total earnings of the company less the earnings of the company less the
total dividends declared since total dividends declared since inception of operations.inception of operations.
Retained earnings is the total Retained earnings is the total earnings of the company less the earnings of the company less the
total dividends declared since total dividends declared since inception of operations.inception of operations.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-27
Companies often purchase shares of its own Companies often purchase shares of its own common stock. This stock is said to be held in the common stock. This stock is said to be held in the
treasury and can be used to satisfy employee treasury and can be used to satisfy employee stock purchase or option plans. Treasury shares stock purchase or option plans. Treasury shares
may also be used in connection with the may also be used in connection with the acquisition of another company.acquisition of another company.
Companies often purchase shares of its own Companies often purchase shares of its own common stock. This stock is said to be held in the common stock. This stock is said to be held in the
treasury and can be used to satisfy employee treasury and can be used to satisfy employee stock purchase or option plans. Treasury shares stock purchase or option plans. Treasury shares
may also be used in connection with the may also be used in connection with the acquisition of another company.acquisition of another company.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-28
Balance Sheet Ratios andDebt Contracts
When a company borrows money, they often agree to certain restrictions on their activity. Ratios typically part of the borrowing agreement include:
Total Liabilities÷ Stockholders' Equity= Debt-to-Equity Ratio
Total Liabilities÷ Stockholders' Equity= Debt-to-Equity Ratio
Current Assets÷ Current Liabilities= Current Ratio
Current Assets÷ Current Liabilities= Current Ratio
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Classified Income Statement
Income statements may contain five Income statements may contain five sections:sections:
1.1. Continuing operationsContinuing operations
2.2. Discontinued operationsDiscontinued operations
3.3. Extraordinary itemsExtraordinary items
4.4. Cumulative effect of changes in Cumulative effect of changes in accounting methodsaccounting methods
5.5. Earnings per shareEarnings per share
Income statements may contain five Income statements may contain five sections:sections:
1.1. Continuing operationsContinuing operations
2.2. Discontinued operationsDiscontinued operations
3.3. Extraordinary itemsExtraordinary items
4.4. Cumulative effect of changes in Cumulative effect of changes in accounting methodsaccounting methods
5.5. Earnings per shareEarnings per share
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
5-30
Classified Income Statement
Net sales− Cost of goods sold
Gross profit− Operating expenses
Income from operations± Nonoperating revenues/expenses and gains/losses
Income before income taxes− Income tax expense
Net income
General Format for the Classified Income StatementGeneral Format for the Classified Income Statement
Gross sales minus any Gross sales minus any discounts, returns, and discounts, returns, and
allowances during the period.allowances during the period.
Gross sales minus any Gross sales minus any discounts, returns, and discounts, returns, and
allowances during the period.allowances during the period.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Classified Income Statement
Net sales− Cost of goods sold
Gross profit− Operating expenses
Income from operations± Nonoperating revenues/expenses and gains/losses
Income before income taxes− Income tax expense
Net income
General Format for the Classified Income StatementGeneral Format for the Classified Income Statement
Cost of inventory sold.Cost of inventory sold.Cost of inventory sold.Cost of inventory sold.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Classified Income Statement
Net sales− Cost of goods sold
Gross profit− Operating expenses
Income from operations± Nonoperating revenues/expenses and gains/losses
Income before income taxes− Income tax expense
Net income
General Format for the Classified Income StatementGeneral Format for the Classified Income Statement
Not related to the company’s primary Not related to the company’s primary operations. Usually includes interest income or operations. Usually includes interest income or
expense and any gains or losses from the expense and any gains or losses from the retirement of equipment.retirement of equipment.
Not related to the company’s primary Not related to the company’s primary operations. Usually includes interest income or operations. Usually includes interest income or
expense and any gains or losses from the expense and any gains or losses from the retirement of equipment.retirement of equipment.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Classified Income Statement
Net sales− Cost of goods sold
Gross profit− Operating expenses
Income from operations± Nonoperating revenues/expenses and gains/losses
Income before income taxes− Income tax expense
Net income
General Format for the Classified Income StatementGeneral Format for the Classified Income StatementIn addition, companies may have nonrecurring items. In addition, companies may have nonrecurring items. These nonrecurring items may include:These nonrecurring items may include:
1. 1. Discontinued operations,Discontinued operations,2. 2. Extraordinary items,Extraordinary items,3. 3. Cumulative effect of changes in accounting methods.Cumulative effect of changes in accounting methods.
These items are reported separately because they are These items are reported separately because they are not useful in predicting future income of the company.not useful in predicting future income of the company.
In addition, companies may have nonrecurring items. In addition, companies may have nonrecurring items. These nonrecurring items may include:These nonrecurring items may include:
1. 1. Discontinued operations,Discontinued operations,2. 2. Extraordinary items,Extraordinary items,3. 3. Cumulative effect of changes in accounting methods.Cumulative effect of changes in accounting methods.
These items are reported separately because they are These items are reported separately because they are not useful in predicting future income of the company.not useful in predicting future income of the company.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Discontinued Operations
Income or loss on Income or loss on segment’s operation for segment’s operation for
the period.the period.
Income or loss on Income or loss on segment’s operation for segment’s operation for
the period.the period.
Gain or loss on Gain or loss on disposal of the disposal of the
segment.segment.
Gain or loss on Gain or loss on disposal of the disposal of the
segment.segment.
Sale or abandonment of a Sale or abandonment of a segmentsegment of a of a business.business.
Sale or abandonment of a Sale or abandonment of a segmentsegment of a of a business.business.
Show net of applicable taxes.Show net of applicable taxes.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Extraordinary Items
UnusualUnusual InfrequentInfrequent
Show net of applicable taxes.Show net of applicable taxes.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Cumulative Effect of Changes in Accounting Methods
The change must be to a The change must be to a preferable preferable methodmethod and must be disclosed in notes and must be disclosed in notes
to financial statements.to financial statements.
The change must be to a The change must be to a preferable preferable methodmethod and must be disclosed in notes and must be disclosed in notes
to financial statements.to financial statements.
GAAP GAAP MethodMethodGAAP GAAP
MethodMethodChange to
AlternativeGAAP GAAP
MethodMethodGAAP GAAP
MethodMethod
Show net of applicable taxes.Show net of applicable taxes.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Classified Income Statement
Now, let’s look at two common Now, let’s look at two common formats for presenting the formats for presenting the
continuing operations section.continuing operations section.1.1.Single-step income statementSingle-step income statement
2.2.Multiple-step income statementMultiple-step income statement
Now, let’s look at two common Now, let’s look at two common formats for presenting the formats for presenting the
continuing operations section.continuing operations section.1.1.Single-step income statementSingle-step income statement
2.2.Multiple-step income statementMultiple-step income statement
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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In the In the single-stepsingle-step format format, all revenues, income, , all revenues, income, and gains are listed first.and gains are listed first.
Costs, expenses, and losses are then subtracted Costs, expenses, and losses are then subtracted from total revenues to get net income.from total revenues to get net income.
In the In the single-stepsingle-step format format, all revenues, income, , all revenues, income, and gains are listed first.and gains are listed first.
Costs, expenses, and losses are then subtracted Costs, expenses, and losses are then subtracted from total revenues to get net income.from total revenues to get net income.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Cost of goods sold is shown along with a Cost of goods sold is shown along with a separation of non-operating income and separation of non-operating income and
expenses and non-recurring items.expenses and non-recurring items.
Cost of goods sold is shown along with a Cost of goods sold is shown along with a separation of non-operating income and separation of non-operating income and
expenses and non-recurring items.expenses and non-recurring items.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Two unusualTwo unusualexpenses that expenses that
may recur in themay recur in thefuture.future.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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A nonrecurringA nonrecurringitem that isitem that ispresentedpresented
separately afterseparately afterincome fromincome fromoperations.operations.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Earnings Per Share
EPS =EPS =Net Income Available to Common ShareholdersNet Income Available to Common Shareholders
Weighted Average Number of Shares Outstanding During the Reporting Period
Weighted Average Number of Shares Outstanding During the Reporting Period
Basic EPSBasic EPSBasic EPSBasic EPS
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Earnings Per Share
EPS =EPS =Net Income Available to Common ShareholdersNet Income Available to Common Shareholders
Weighted Average Number of Shares Outstanding During the Reporting Period
Weighted Average Number of Shares Outstanding During the Reporting Period
Diluted EPSDiluted EPSStock options, debt securities, Stock options, debt securities,
equity securities are assumed to equity securities are assumed to be converted into common stock be converted into common stock at the beginning of the period.at the beginning of the period.
Diluted EPSDiluted EPSStock options, debt securities, Stock options, debt securities,
equity securities are assumed to equity securities are assumed to be converted into common stock be converted into common stock at the beginning of the period.at the beginning of the period.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Both basic and Both basic and diluted EPS are diluted EPS are reported here.reported here.
Both basic and Both basic and diluted EPS are diluted EPS are reported here.reported here.
© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Accounting-Based Executive Bonuses
Executives are frequently paid bonuses based upon pretax earnings
growth of the company.
Pre-Tax EarningsGrowth Percent
=
Last Year Pretax Earnings
Current YearPretax Earnings
Last YearPretax Earnings−
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Statement of Cash Flows
Recall that the Statement of Cash Flows Recall that the Statement of Cash Flows is divided into is divided into threethree major sections. major sections.
1.1. Cash flows from operating activities.Cash flows from operating activities.
2.2. Cash flows from investing activities.Cash flows from investing activities.
3.3. Cash flows from financing activities.Cash flows from financing activities.
We will examine the indirect method of We will examine the indirect method of preparing the statement. This format preparing the statement. This format begins with a begins with a reconciliationreconciliation of accrual of accrual income to cash flows from operations.income to cash flows from operations.
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The operating The operating activities section of activities section of Callaway using theCallaway using the
indirect methodindirect method. . Begin with Begin with
accounting net accounting net income and arrive income and arrive
at cash provided by at cash provided by operating activities.operating activities.
The operating The operating activities section of activities section of Callaway using theCallaway using the
indirect methodindirect method. . Begin with Begin with
accounting net accounting net income and arrive income and arrive
at cash provided by at cash provided by operating activities.operating activities.
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While these While these items are on items are on the income the income
statement, they statement, they have no have no
current cash current cash effect.effect.
While these While these items are on items are on the income the income
statement, they statement, they have no have no
current cash current cash effect.effect.
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This table This table provides provides
guidance for guidance for adjustments adjustments
related to related to changes in changes in
current assets current assets and current and current liabilities.liabilities.
This table This table provides provides
guidance for guidance for adjustments adjustments
related to related to changes in changes in
current assets current assets and current and current liabilities.liabilities.
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Here is the rest Here is the rest of Callaway’s of Callaway’s Statement of Statement of Cash Flows Cash Flows showing the showing the
cash balance cash balance on the on the
company’s company’s balance sheet.balance sheet.
Here is the rest Here is the rest of Callaway’s of Callaway’s Statement of Statement of Cash Flows Cash Flows showing the showing the
cash balance cash balance on the on the
company’s company’s balance sheet.balance sheet.
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Notes to Financial Statements
Descriptions of the key accounting rules Descriptions of the key accounting rules applies to the company’s statements.applies to the company’s statements.
Descriptions of the key accounting rules Descriptions of the key accounting rules applies to the company’s statements.applies to the company’s statements.
Additional detail supporting reported Additional detail supporting reported numbers.numbers.
Additional detail supporting reported Additional detail supporting reported numbers.numbers.
Relevant financial information not Relevant financial information not disclosed on the statements.disclosed on the statements.
Relevant financial information not Relevant financial information not disclosed on the statements.disclosed on the statements.
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Return on Equity (ROE)
1(beginning equity + ending equity) ÷ 2
Return Return onon
EquityEquity==
Net IncomeNet IncomeAverage Stockholder’s EquityAverage Stockholder’s Equity11
ROE measures how much the firm earned for each dollar of stockholders’ investment.
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ROE Profit Driver Analysis
ROEROE Net ProfitMargin
Net ProfitMargin
AssetTurnover
AssetTurnover
FinancialLeverageFinancialLeverage= ××
Net IncomeAverage
Stockholders’Equity
Net IncomeAverage
Stockholders’Equity
Net IncomeNet Sales
Net IncomeNet Sales
Net SalesAverage
Total Assets
Net SalesAverage
Total Assets
AverageTotal Assets
AverageStockholders’
Equity
AverageTotal Assets
AverageStockholders’
Equity
× ×
=
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The End of Chapter 5