Financial Reporting and Analysis 5

Foundations of Financial Reporting

OBJECTIVE 1: Describe the objective of financial reporting and identify the qualitative characteristics, conventions, and ethical considerations of accounting information.

Figure 1: Factors Affecting Financial Reporting

Foundations of Financial Reporting

• Objective of financial reporting– Assess cash flow prospects

• Ability to pay dividends, interest and returns to capital

– Assess stewardship• Provide information about business resources, claims to

those resources, and changes in them

– General-purpose external financial statements consist of the balance sheet, income statement, statement of retained earnings, and statement of cash flows.

Foundations of Financial Reporting

• Qualitative characteristics facilitates a user’s interpretations of accounting information– Information should be relevant, meaning it has

direct bearing on a decision• Predictive value

• Confirmative value

• Both

Foundations of Financial Reporting

• Qualitative characteristics facilitates a user’s interpretations of accounting information (cont.)– The information should be a faithful

representation of the entity.• Complete, neutral, and free from material error

– Information does not have to be absolutely accurate but major uncertainties should be disclosed.

Foundations of Financial Reporting

• Qualitative characteristics facilitates a user’s interpretations of accounting information (cont.)– Four qualitative characteristics complement the

quality of information• Comparability

• Verifiability

• Timeliness

• Understandability

Foundations of Financial Reporting

• Accounting conventions are constraints on accounting and the preparation of financial statements to better enable the user to understand the information being presented.

• Under the Sarbanes-Oxley Act, the CEO and CFO of public companies must certify the financial statements and the system of internal control.

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Accounting Conventions for Preparing Financial Statements

OBJECTIVE 2: Define and describe the conventions of consistency, full disclosure, materiality, conservatism, and cost-benefit.

Accounting Conventions for Preparing Financial Statements

• Consistency– Once a company has adopted an accounting

procedure, it must use it from one period to the next unless otherwise noted.

Accounting Conventions for Preparing Financial Statements

• Full disclosure (transparency)– Financial statements must present all

information relevant to users’ understanding of the statements

– Explanatory notes disclosing changes in account procedures, or significant events occurring after balance sheet dates

Accounting Conventions for Preparing Financial Statements

• Materiality– Relative importance of an item or event– Materiality determined by relating its dollar

value to an element of the financial statements

Accounting Conventions for Preparing Financial Statements

• Conservatism– When a choice between two equally acceptable

procedures, chose the one least like to overstate assets or income

– Useful, but can be abused, so accountants should only depend on it when uncertain about which procedure or estimate to use.

• Cost-benefit– The benefit gained from providing information should

be greater than the cost of providing it.– Costs and benefits are both immediate and deferred.

Accounting Conventions for Preparing Financial Statements

• Cost-benefit– The benefit gained from providing information

should be greater than the cost of providing it.– Costs and benefits are both immediate and

deferred.

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Classified Balance Sheet

OBJECTIVE 3: Identify and describe the basic components of a classified balance sheet.

Classified Balance Sheet

• Classified financial statements are general-purpose external financial statements that are divided into subcategories to provide more useful information to the reader.

• A classified balance sheet divides assets, liabilities, and owner’s equity into subcategories to facilitate decision-making.

Figure 2 Classified Balance Sheet

Classified Balance Sheet

• There are usually four categories of assets on the classified balance sheet. These categories are listed in declining order of liquidity. (Some companies use another category called other assets to group all assets other than current assets and property, plant, and equipment.) – Current assets

• The normal operating cycle, a concept used in the classification of assets, is the time a company needs to go from spending cash to receiving cash.

– Investments– Property, plant, and equipment– Intangible assets

Classified Balance Sheet

• Liabilities on the classified balance sheet are usually divided into two categories.– Current liabilities– Long-term liabilities

• In a sole proprietorship the owner’s equity section shows the capital in the owner’s name at an amount equal to the net assets of the company.

Exhibit 1 Classified Balance Sheet for Cruz Company

Exhibit 1 Classified Balance Sheet for Cruz Company (cont.)

Exhibit 2 Classified Balance Sheet for Dell Corporation

Exhibit 2 (Continued)

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Forms of the Income Statement

OBJECTIVE 4: Describe the features of multistep and single-step classified income statements.

Figure 3: The Components of Multistep Income Statements for Service and Merchandising or Manufacturing Companies

Exhibit 3: Multistep Income Statement for Cruz Company

Exhibit 4: Multistep Income Statement for Dell Computer Corporation

Exhibit 5: Single-Step Income Statement for Cruz Company

Forms of the Income Statement

• The multistep income statement arrives at net income through a series of steps, or subtotals, including gross margin and income from operations.– Net sales– Cost of goods sold– Gross margin– Operating expenses– Income from operations– Other revenues and expenses– Income taxes– Net income

Forms of the Income Statement

• The single-step income statement arrives at net income in a single step. The single-step form is a simple deduction of all costs and expenses from all revenues.

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Using Classified Financial Statements

OBJECTIVE 5: Use classified financial statements to evaluate liquidity and profitability.

Figure 4: Average Current Ratio for Selected Industries

Figure 5: Average Profit Margin for Selected Industries

Figure 6: Average Asset Turnover for Selected Industries

Figure 7: Average Return on Assets for Selected Industries

Figure 8: Average Debt to Equity Ratio for Selected Industries

Figure 9: Average Return on Equity for Selected Industries

Using Classified Financial Statements

• Liquidity measures a company’s ability to pay its bills when they fall due.– Working capital is current assets minus current

liabilities.– The current ratio is current assets divided by

current liabilities.

Using Classified Financial Statements

• Profitability may be measured several ways.– Profit margin—net income divided by net sales– Asset turnover—net sales divided by average total assets– Return on assets—net income divided by average total

assets– Debt to equity ratio—total liabilities divided by owner’s

equity– Return on equity—net income divided by average

owner’s equity

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Exhibit S-1: CVS’s Income Statements

Exhibit S-2: CVS’s Balance Sheets

Exhibit S-2: CVS’s Balance Sheets (cont’d)

Exhibit S-3: CVS’s Statements of Cash Flows

Exhibit S-3: CVS’s Statements of Cash Flows

Exhibit S-4: CVS’s Statements of Shareholders’ Equity

Exhibit S-4: CVS’s Statements of Shareholders’ Equity

Exhibit S-4: CVS’s Statements of Shareholders’ Equity

Figure S-1: Auditor’s Report for CVS Caremark Corporation

Supplement to Chapter 5: How to Read an Annual Report

• Components of an Annual Reports– Letter to the Stockholders– Financial Highlights– Description of the Company– Management’s Discussion and Analysis

Supplement to Chapter 5: How to Read an Annual Report

• Financial Statements– Formal financial statements appear in an

annual report, usually in comparative form.– Consolidated financial statements are

combined statements of affiliated companies.– A statement of stockholders’ equity often

replaces the owner’s equity statement.

Supplement to Chapter 5: How to Read an Annual Report

• Notes to the Financial Statements– A summary of significant accounting policies

should accompany the financial statements.– Notes to the financial statements interpret

portions of the financial statements.– Corporations frequently issue interim financial

statements that cover less than a year.

Supplement to Chapter 5: How to Read an Annual Report

• An annual report usually includes a report of management’s responsibilities as well as management’s discussion and analysis of operations.

Supplement to Chapter 5: How to Read an Annual Report

• The independent auditors’ report accompanies the financial statements.– The first paragraph identifies the financial

statements and responsibilities.– The scope section describes the extent of the

examination.– The opinion section expresses the fairness of

presentation of the financial statements.– The fourth paragraph identifies any new accounting

standards adopted by the company– The fifth paragraph says the company’s internal

controls are effective.