CHAPTER 2
A FURTHER LOOK AT FINANCIAL STATEMENTS
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
- Identify the sections of a classified balance sheet.
- Identify tools for analyzing financial statements and ratios for computing a company's profitability.
- Explain the relationship between a retained earnings statement and a statement of stockholders’ equity.
- Identify and compute ratios for analyzing a company's liquidity and solvency using a balance sheet.
- Use the statement of cash flows to evaluate solvency.
- Explain the meaning of generally accepted accounting principles.
- Discuss financial reporting concepts.
Feature Story
JUST FOOLING AROUND?
Few people could have predicted how dramatically the Internet would change the investment world. One of the most interesting results is how it has changed the way ordinary people invest their savings. More and more people are striking out on their own, making their own investment decisions.
Two early pioneers in providing investment information to the masses were Tom and David Gardner, brothers who created an online investor website called The Motley Fool. The name comes from Shakespeare's As You Like It. The fool in Shakespeare's plays was the only one who could speak unpleasant truths to kings and queens without being killed. Tom and David view themselves as 21st-century “fools,” revealing the “truths” of Wall Street to the small investor, who they feel has been taken advantage of by Wall Street insiders. The Motley Fool's online bulletin board enables investors to exchange information and insights about companies.
Critics of these bulletin boards contend that they are simply high-tech rumor mills that cause investors to bid up stock prices to unreasonable levels. For example, the stock of PairGain Technologies jumped 32 percent in a single day as a result of a bogus takeover rumor on an investment bulletin board. Some observers are concerned that small investors—ironically, the very people the Gardner brothers are trying to help—will be hurt the most by misinformation and intentional scams.
To show how these bulletin boards work, suppose that in a recent year you had $10,000 to invest. You were considering Best Buy Company, the largest seller of electronics equipment in the United States. You scanned the Internet investment bulletin boards and found messages posted by two different investors. Here are excerpts from actual postings during the same year:
TMPVenus: “Where are the prospects for positive movement for this company? Poor margins, poor management, astronomical P/E!”
broachman: “I believe that this is a LONG TERM winner, and presently at a good price.”
One says sell, and one says buy. Whom should you believe? If you had taken “broachman's” advice and purchased the stock, the $10,000 you invested would have been worth over $300,000 five years later. Best Buy was one of America's best-performing stocks during that period of time.
Rather than getting swept away by rumors, investors must sort out the good information from the bad. One thing is certain—as information services such as The Motley Fool increase in number, gathering information will become even easier. Evaluating it will be the harder task.
INSIDE CHAPTER 2…
- Can a Company Be Too Liquid? (p. 59)
- When Debt Is Good (p. 60)
- The Korean Discount (p. 63)
- What Do These Companies Have in Common? (p. 64)
PREVIEW OF CHAPTER 2
If you are thinking of purchasing Best Buy stock, or any stock, how can you decide what the stock is worth? If you manage J. Crew's credit department, how should you determine whether to extend credit to a new customer? If you are a financial executive of IBM, how do you decide whether your company is generating adequate cash to expand operations without borrowing? Your decision in each of these situations will be influenced by a variety of considerations. One of them should be your careful analysis of a company's financial statements. The reason: Financial statements offer relevant and reliable information, which will help you in your decision-making.
In this chapter, we take a closer look at the balance sheet and introduce some useful ways for evaluating the information provided by the financial statements. We also examine the financial reporting concepts underlying the financial statements. We begin by introducing the classified balance sheet.
The Classified Balance Sheet
LEARNING OBJECTIVE 1
Identify the sections of a classified balance sheet.
In Chapter 1, you learned that a balance sheet presents a snapshot of a company's financial position at a point in time. It lists individual asset, liability, and stockholders’ equity items. However, to improve users’ understanding of a company's financial position, companies often use a classified balance sheet instead. A classified balance sheet groups together similar assets and similar liabilities, using a number of standard classifications and sections. This is useful because items within a group have similar economic characteristics. A classified balance sheet generally contains the standard classifications listed in Illustration 2-1.
These groupings help financial statement readers determine such things as (1) whether the company has enough assets to pay its debts as they come due, and (2) the claims of short- and long-term creditors on the company's total assets. Many of these groupings can be seen in the balance sheet of Franklin Corporation shown in Illustration 2-2. In the sections that follow, we explain each of these groupings.
CURRENT ASSETS
Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2-2, Franklin Corporation had current assets of $22,100. For most businesses, the cutoff for classification as current assets is one year from the balance sheet date. For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use the supplies in operations within one year.
Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year. The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers. For most businesses, this cycle takes less than a year, so they use a one-year cutoff. But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long-term.
Common types of current assets are (1) cash, (2) investments (such as short-term U.S. government securities), (3) receivables (accounts receivable, notes receivable, and interest receivable), (4) inventories, and (5) prepaid expenses (insurance and supplies). Companies list current assets in the order in which they expect to convert them into cash. Follow this rule when doing your homework.
Illustration 2-3 presents the current assets of Southwest Airlines Co. in a recent year.
As explained later in the chapter, a company's current assets are important in assessing its short-term debt-paying ability.
LONG-TERM INVESTMENTS
Alternative Terminology Long-term investments are often referred to simply as investments.
Long-term investments are generally: (1) investments in stocks and bonds of other corporations that are held for more than one year, (2) long-term assets such as land or buildings that a company is not currently using in its operating activities, and (3) long-term notes receivable. In Illustration 2-2, Franklin Corporation reported total long-term investments of $7,200 on its balance sheet.
Yahoo! Inc. reported long-term investments on its balance sheet in a recent year as shown in Illustration 2-4.
PROPERTY, PLANT, AND EQUIPMENT
Alternative Terminology Property, plant, and equipment is sometimes called fixed assets or plant assets.
Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business. This category includes land, buildings, equipment, delivery vehicles, and furniture. In Illustration 2-2, Franklin Corporation reported property, plant, and equipment of $29,000.
International Note In 2007, China adopted International Financial Reporting Standards (IFRS). This was done in an effort to reduce fraud and increase investor confidence in financial reports. Under these standards, many items, such as property, plant, and equipment, may be reported at current fair values rather than historical cost.
Depreciation is the allocation of the cost of an asset to a number of years. Companies do this by systematically assigning a portion of an asset's cost as an expense each year (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset's life. In Illustration 2-2, Franklin Corporation reported accumulated depreciation of $5,000.
Illustration 2-5 presents the property, plant, and equipment of Cooper Tire & Rubber Company in a recent year.
INTANGIBLE ASSETS
Helpful Hint Sometimes intangible assets are reported under a broader heading called “Other assets.”
Many companies have assets that do not have physical substance and yet often are very valuable. We call these assets intangible assets. One common intangible is goodwill. Others include patents, copyrights, and trademarks or trade names that give the company exclusive right of use for a specified period of time. Franklin Corporation reported intangible assets of $3,100.
Illustration 2-6 shows the intangible assets of media giant Time Warner, Inc. in a recent year.
Do it!
ASSETS SECTION OF CLASSIFIED BALANCE SHEET
Baxter Hoffman recently received the following information related to Hoffman Corporation's December 31, 2014, balance sheet.
Prepare the assets section of Hoffman Corporation's classified balance sheet.
Action Plan
- Present current assets first. Current assets are cash and other resources that the company expects to convert to cash or use up within one year.
- Present current assets in the order in which the company expects to convert them into cash.
- Subtract accumulated depreciation—equipment from equipment to determine net equipment.
Solution
Related exercise material: BE2-2, 
2-1, and E2-4.
CURRENT LIABILITIES
In the liabilities and stockholders’ equity section of the balance sheet, the first grouping is current liabilities. Current liabilities are obligations that the company is to pay within the next year or operating cycle, whichever is longer. Common examples are accounts payable, salaries and wages payable, notes payable, interest payable, and income taxes payable. Also included as current liabilities are current maturities of long-term obligations—payments to be made within the next year on long-term obligations. In Illustration 2-2, Franklin Corporation reported five different types of current liabilities, for a total of $16,050.
Illustration 2-7 shows the current liabilities section adapted from the balance sheet of Marcus Corporation in a recent year.
LONG-TERM LIABILITIES
Long-term liabilities (long-term debt) are obligations that a company expects to pay after one year. Liabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities. Many companies report long-term debt maturing after one year as a single amount in the balance sheet and show the details of the debt in notes that accompany the financial statements. Others list the various types of long-term liabilities. In Illustration 2-2, Franklin Corporation reported long-term liabilities of $11,300.
Illustration 2-8 shows the long-term liabilities that The Procter & Gamble Company reported in its balance sheet in a recent year.
STOCKHOLDERS’ EQUITY
Alternative Terminology Common stock is sometimes called capital stock.
Stockholders’ equity consists of two parts: common stock and retained earnings. Companies record as common stock the investments of assets into the business by the stockholders. They record as retained earnings the income retained for use in the business. These two parts, combined, make up stockholders’ equity on the balance sheet. In Illustration 2-2 (page 49), Franklin reported common stock of $14,000 and retained earnings of $20,050.
Do it!
BALANCE SHEET CLASSIFICATIONS
The following financial statement items were taken from the financial statements of Callahan Corp.
______ Salaries and wages payable
______ Service revenue
______ Interest payable
______ Goodwill
______ Debt investments (short-term)
______ Mortgage payable (due in 3 years)
______ Investment in real estate
______ Equipment
______ Accumulated depreciation—equipment
______ Depreciation expense
______ Retained earnings
______ Unearned service revenue
Match each of the items to its proper balance sheet classification, shown below. If the item would not appear on a balance sheet, use “NA.”
Current assets (CA)
Long-term investments (LTI)
Property, plant, and equipment (PPE)
Intangible assets (IA)
Current liabilities (CL)
Long-term liabilities (LTL)
Stockholders’ equity (SE)
Action Plan
- Analyze whether each financial statement item is an asset, liability, or stockholders’ equity item.
- Determine if asset and liability items are current or long-term.
Solution
| CL | Salaries and wages payable |
| NA | Service revenue |
| CL | Interest payable |
| IA | Goodwill |
| CA | Debt investments (short-term) |
| LTL | Mortgage payable (due in 3 years) |
| LTI | Investment in real estate |
| PPE | Equipment |
| PPE | Accumulated depreciation—equipment |
| NA | Depreciation expense |
| SE | Retained earnings |
| CL | Unearned service revenue |
Related exercise material: BE2-1, 2-2, E2-1, E2-2, E2-3, E2-5 and E2-6.
Using the Financial Statements
Identify tools for analyzing financial statements and ratios for computing a company's profitability.
In Chapter 1, we introduced the four financial statements. We discussed how these statements provide information about a company's performance and financial position. In this chapter, we extend this discussion by showing you specific tools that you can use to analyze financial statements in order to make a more meaningful evaluation of a company.
RATIO ANALYSIS
Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. For analysis of the primary financial statements, we classify ratios as follows.
A single ratio by itself is not very meaningful. Accordingly, in this and the following chapters, we will use various comparisons to shed light on company performance:
- Intracompany comparisons covering two years for the same company.
- Industry-average comparisons based on average ratios for particular industries.
- Intercompany comparisons based on comparisons with a competitor in the same industry.
Next, we'll use some ratios and comparisons to analyze the financial statements of Best Buy Company.
USING THE INCOME STATEMENT
Best Buy Company generates profits for its stockholders by selling electronics. The income statement reports how successful it is at generating a profit from its sales. The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses). Illustration 2-10 shows a simplified income statement for Best Buy.
From this income statement, we can see that Best Buy's sales increased but net income decreased during the period. Net income decreased from $1,317 million to $1,277 million. A much smaller competitor of Best Buy is hhgregg. hhgregg operates 173 stores in 15 states and is headquartered in Indianapolis, Indiana. It reported net income of $48.2 million for the year ended March 31, 2011.
To evaluate the profitability of Best Buy, we will use ratio analysis. Profitability ratios, such as earnings per share, measure the operating success of a company for a given period of time.
Earnings per Share
Earnings per share (EPS) measures the net income earned on each share of common stock. We compute EPS by dividing net income minus preferred dividends by the average number of common shares outstanding during the year. Stockholders usually think in terms of the number of shares they own or plan to buy or sell, so stating net income earned as a per share amount provides a useful perspective for determining the investment return. Advanced accounting courses present more refined techniques for calculating earnings per share.
For now, a basic approach for calculating earnings per share is to divide earnings available to common stockholders by average common shares outstanding during the year. What is “earnings available to common stockholders”? It is an earnings amount calculated as net income less dividends paid on another type of stock, called preferred stock (Net income − Preferred dividends).
By comparing earnings per share of a single company over time, we can evaluate its relative earnings performance from the perspective of a stockholder—that is, on a per share basis. It is very important to note that comparisons of earnings per share across companies are not meaningful because of the wide variations in the numbers of shares of outstanding stock among companies.
Illustration 2-11 (page 56) shows the earnings per share calculation for Best Buy in 2011 and 2010, based on the information presented below. (Note that to simplify our calculations, we assumed that any change in the number of shares for Best Buy occurred in the middle of the year.)
DECISION TOOLKIT
USING THE STATEMENT OF STOCKHOLDERS’ EQUITY
LEARNING OBJECTIVE 3
Explain the relationship between a retained earnings statement and a statement of stockholders’ equity.
As discussed in Chapter 1, the retained earnings statement describes the changes in retained earnings during the year. This statement adds net income to beginning retained earnings and then subtracts dividends to arrive at ending retained earnings.
Stockholders’ equity is comprised of two parts: retained earnings and common stock. Therefore, the stockholders’ equity of most companies is affected by factors other than just changes in retained earnings. For example, the company may issue or retire shares of common stock. Most companies, therefore, use what is called a statement of stockholders’ equity rather than a retained earnings statement. This statement presents the causes of changes to stockholders’ equity during the period, including those that caused retained earnings to change. Illustration 2-12 is a simplified statement of stockholders’ equity for Best Buy.
We can observe from this financial statement that Best Buy's common stock increased in the first year as the result of an issuance of shares. However, Best Buy's common stock decreased during the second year. Even though it had an issuance of common stock, that increase was much smaller than the decrease caused by a stock repurchase. Another observation from this financial statement is that Best Buy paid dividends each year. This is a relatively recent practice for Best Buy. For many years, it did not pay dividends, even though it was profitable and could do so. You might wonder why Best Buy paid no dividends during years when it was profitable. In fact, in a prior year, two Best Buy stockholders discussed this question about the company's dividend policy on an investor bulletin board. Here are excerpts:
Katwoman: “Best Buy has a nice price increase. Earnings are on the way up. But why no dividends?”
AngryCandy: “I guess they feel they can make better use of the money by investing back in the business. They still view Best Buy as a rapidly growing company and would prefer to invest in expanding the infrastructure (building new stores, advertising, etc.) than in paying out dividends…. If Best Buy gets to the stage of ‘stable, big company’ with little room for expansion, then I'm sure you'll see them elect to pay out a dividend.”
AngryCandy's response is an excellent explanation of the thought process that management goes through in deciding whether to pay a dividend. Management must evaluate what its cash needs are. If it has uses for cash that will increase the value of the company (for example, building a new warehouse), then it should retain cash in the company. However, if it has more cash than it has valuable opportunities, it should distribute its excess cash as a dividend.
USING A CLASSIFIED BALANCE SHEET
LEARNING OBJECTIVE 4
Identify and compute ratios for analyzing a company's liquidity and solvency using a balance sheet.
You can learn a lot about a company's financial health by also evaluating the relationship between its various assets and liabilities. Illustration 2-13 provides a simplified balance sheet for Best Buy.
Liquidity
Suppose you are a banker at CitiGroup considering lending money to Best Buy, or you are a sales manager at Hewlett-Packard interested in selling computers to Best Buy on credit. You would be concerned about Best Buy's liquidity—its ability to pay obligations expected to become due within the next year or operating cycle. You would look closely at the relationship of its current assets to current liabilities.
WORKING CAPITAL. One measure of liquidity is working capital, which is the difference between the amounts of current assets and current liabilities:
When current assets exceed current liabilities, working capital is positive. When this occurs, there is greater likelihood that the company will pay its liabilities. When working capital is negative, a company might not be able to pay short-term creditors, and the company might ultimately be forced into bankruptcy. Best Buy had working capital in 2011 of $1,810 million ($10,473 million − $8,663 million).
CURRENT RATIO. Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. One liquidity ratio is the current ratio, computed as current assets divided by current liabilities.
The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have significantly different current ratios. Illustration 2-15 shows the 2011 and 2010 current ratios for Best Buy and for hhgregg, along with the 2011 industry average.
What does the ratio actually mean? Best Buy's 2011 current ratio of 1.21:1 means that for every dollar of current liabilities, Best Buy has $1.21 of current assets. Best Buy's current ratio increased in 2011. When compared to the industry average of 1.5:1, Best Buy's liquidity seems low. It is also less than hhgregg's.
Ethics Note A company that has more current assets than current liabilities can increase the ratio of current assets to current liabilities by using cash to pay off some current liabilities. This gives the appearance of being more liquid. Do you think this move is ethical?
One potential weakness of the current ratio is that it does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose whether a portion of the current assets is tied up in slow-moving inventory. The composition of the current assets matters because a dollar of cash is more readily available to pay the bills than is a dollar of inventory. For example, suppose a company's cash balance declined while its merchandise inventory increased substantially. If inventory increased because the company is having difficulty selling its products, then the current ratio might not fully reflect the reduction in the company's liquidity.
Accounting Across the Organization
Can a Company Be Too Liquid?
There actually is a point where a company can be too liquid—that is, it can have too much working capital. While it is important to be liquid enough to be able to pay short-term bills as they come due, a company does not want to tie up its cash in extra inventory or receivables that are not earning the company money.
By one estimate from the REL Consultancy Group, the thousand largest U.S. companies had cumulative excess working capital of $1.017 trillion in a recent year. This was an 18% increase, which REL said represented a “deterioration in the management of operations.” Given that managers throughout a company are interested in improving profitability, it is clear that they should have an eye toward managing working capital. They need to aim for a “Goldilocks solution”—not too much, not too little, but just right.
Source: Maxwell Murphy, “The Big Number,” Wall Street Journal (November 9, 2011).
What can various company managers do to ensure that working capital is managed efficiently to maximize net income? (See page 95.)
Solvency
Now suppose that instead of being a short-term creditor, you are interested in either buying Best Buy's stock or extending the company a long-term loan. Long-term creditors and stockholders are interested in a company's solvency—its ability to pay interest as it comes due and to repay the balance of a debt due at its maturity. Solvency ratios measure the ability of the company to survive over a long period of time.
DEBT TO ASSETS RATIO. The debt to assets ratio is one measure of solvency. It is calculated by dividing total liabilities (both current and long-term) by total assets. It measures the percentage of total financing provided by creditors rather than stockholders. Debt financing is more risky than equity financing because debt must be repaid at specific points in time, whether the company is performing well or not. Thus, the higher the percentage of debt financing, the riskier the company.
Helpful Hint Some users evaluate solvency using a ratio of liabilities divided by stockholders’ equity. The higher this “debt to equity” ratio, the lower is a company's solvency.
The higher the percentage of total liabilities (debt) to total assets, the greater the risk that the company may be unable to pay its debts as they come due. Illustration 2-16 shows the debt to assets ratios for Best Buy and hhgregg, along with the 2011 industry average.
The 2011 ratio of 59% means that every dollar of assets was financed by 59 cents of debt. Best Buy's ratio exceeds the industry average of 57% and is significantly higher than hhgregg's ratio of 42%. The higher the ratio, the more reliant the company is on debt financing. This means the company has a lower equity “buffer” available to creditors if the company becomes insolvent. Thus, from the creditors’ point of view, a high ratio of debt to assets is undesirable. Best Buy's solvency appears lower than hhgregg's and lower than the average company in the industry.
The adequacy of this ratio is often judged in the light of the company's earnings. Generally, companies with relatively stable earnings, such as public utilities, can support higher debt to assets ratios than can cyclical companies with widely fluctuating earnings, such as many high-tech companies. In later chapters, you will learn additional ways to evaluate solvency.
Investor Insight
When Debt Is Good
Debt financing differs greatly across industries and companies. Here are some debt to assets ratios for selected companies in a recent year:
Discuss the difference in the debt to assets ratio of Microsoft and General Motors. (See page 95.)
KEEPING AN EYE ON CASH
LEARNING OBJECTIVE 5
Use the statement of cash flows to evaluate solvency.
In the statement of cash flows, net cash provided by operating activities is intended to indicate the cash-generating capability of the company. Analysts have noted, however, that net cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment (capital expenditures) just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. A measurement to provide additional insight regarding a company's cash-generating ability is free cash flow. Free cash flow describes the net cash provided by operating activities after adjusting for capital expenditures and dividends paid.
Consider the following example. Suppose that MPC produced and sold 10,000 personal computers this year. It reported $100,000 net cash provided by operating activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash flow was $80,000 ($100,000 − $15,000 − $5,000). The company could use this $80,000 to purchase new assets to expand the business, pay off debts, or increase its dividend distribution. In practice, analysts often calculate free cash flow with the formula shown below. (Alternative definitions also exist.)
We can calculate Best Buy's 2011 free cash flow as follows (dollars in millions).
Best Buy generated free cash flow of $209 million which is available for the acquisition of new assets, the retirement of stock or debt, or the payment of additional dividends. Long-term creditors consider a high free cash flow amount an indication of solvency. hhgregg's free cash flow for 2011 is a negative $0.9 million. Given that hhgregg is considerably smaller than Best Buy, we would expect its free cash flow to be much lower. But, negative free cash flow could be cause for concern.
DECISION TOOLKIT
Do it!
The following information is available for Ozone Inc.
(a) Compute earnings per share for 2014 and 2013 for Ozone, and comment on the change. Ozone's primary competitor, Frost Corporation, had earnings per share of $2 in 2014. Comment on the difference in the ratios of the two companies.
(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.
(c) Compute free cash flow for each year, and comment on the changes.
Action Plan
- Use the formula for earnings per share (EPS): (Net income − Preferred dividends) ÷ (Average common shares outstanding).
- Use the formula for the current ratio: Current assets ÷ Current liabilities.
- Use the formula for the debt to assets ratio: Total liabilities ÷ Total assets.
- Use the formula for free cash flow: Net cash provided by operating activities − Capital expenditures − Cash dividends.
Solution
Related exercise material: BE2-3, BE2-5, BE2-6, 2-3, E2-7, E2-9, E2-10, and E2-11.
Financial Reporting Concepts
You have now learned about the four financial statements and some basic ways to interpret those statements. In this last section, we will discuss concepts that underlie these financial statements. It would be unwise to make business decisions based on financial statements without understanding the implications of these concepts.
THE STANDARD-SETTING ENVIRONMENT
How does Best Buy decide on the type of financial information to disclose? What format should it use? How should it measure assets, liabilities, revenues, and expenses? Accounting professionals at Best Buy and all other U.S. companies get guidance from a set of accounting standards that have authoritative support, referred to as generally accepted accounting principles (GAAP). Standard-setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards.
International Note Over 115 countries use international standards (called IFRS). For example, all companies in the European Union follow IFRS. In this textbook, we highlight any significant differences using International Notes like this one, as well as a more in-depth discussion in the A Look at IFRS section at the end of each chapter.
The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies. The Financial Accounting Standards Board (FASB) is the primary accounting standard-setting body in the United States. The International Accounting Standards Board (IASB) issues standards called International Financial Reporting Standards (IFRS), which have been adopted by many countries outside of the United States. Today, the FASB and IASB are working closely together to minimize the differences in their standards. Recently, the SEC announced that foreign companies that wish to have their shares traded on U.S stock exchanges no longer have to prepare reports that conform with GAAP, as long as their reports conform with IFRS. The SEC is currently evaluating whether the United States should eventually adopt IFRS as the required set of standards for U.S. publicly traded companies. Another relatively recent change to the financial reporting environment was that, as a result of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) was created. Its job is to determine auditing standards and review the performance of auditing firms. If the United States adopts IFRS for its accounting standards, it will also have to coordinate its auditing regulations with those of other countries.
International Insight
The Korean Discount
If you think that accounting standards don't matter, consider recent events in South Korea. For many years, international investors complained that the financial reports of South Korean companies were inadequate and inaccurate. Accounting practices there often resulted in huge differences between stated revenues and actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of comparable companies in different countries. This difference in share price was often referred to as the “Korean discount.”
In response, Korean regulators decided that, beginning in 2011, companies would have to comply with international accounting standards. This change was motivated by a desire to “make the country's businesses more transparent” in order to build investor confidence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international standards or to create standards that are based on the international standards.
Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).
What is meant by the phrase “make the country's businesses more transparent”? Why would increasing transparency spur economic growth? (See page 95.)
QUALITIES OF USEFUL INFORMATION
Recently, the FASB and IASB completed the first phase of a joint project in which they developed a conceptual framework to serve as the basis for future accounting standards. The framework begins by stating that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 2-17.
Enhancing Qualities
In addition to the two fundamental qualities, the FASB and IASB also describe a number of enhancing qualities of useful information. These include comparability, consistency, verifiability, timeliness, and understandability. In accounting, comparability results when different companies use the same accounting principles. Another characteristic that enhances comparability is consistency. Consistency means that a company uses the same accounting principles and methods from year to year. Information is verifiable if independent observers, using the same methods, obtain similar results. As noted in Chapter 1, certified public accountants (CPAs) perform audits of financial statements to verify their accuracy. For accounting information to have relevance, it must be timely. That is, it must be available to decision-makers before it loses its capacity to influence decisions. The SEC requires that public companies provide their annual reports to investors within 60 days of their year-end. Information has the quality of understandability if it is presented in a clear and concise fashion, so that reasonably informed users of that information can interpret it and comprehend its meaning.
Accounting Across the Organization
What Do These Companies Have in Common?
Another issue related to comparability is the accounting time period. An accounting period that is one-year long is called a fiscal year. But a fiscal year need not match the calendar year. For example, a company could end its fiscal year on April 30, rather than December 31.
Why do companies choose the particular year-ends that they do? For example, why doesn't every company use December 31 as the accounting year-end? Many companies choose to end their accounting year when inventory or operations are at a low point. This is advantageous because compiling accounting information requires much time and effort by managers, so they would rather do it when they aren't as busy operating the business. Also, inventory is easier and less costly to count when its volume is low.
Some companies whose year-ends differ from December 31 are Delta Air Lines, June 30; Walt Disney Productions, September 30; and Dunkin’ Donuts, Inc., October 31. In the notes to its financial statements, Best Buy states that its accounting year-end is the Saturday nearest the end of February.
What problems might Best Buy's year-end create for analysts? (See page 95.)
ASSUMPTIONS IN FINANCIAL REPORTING
To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 2-18. These include assumptions about the monetary unit, economic entity, periodicity, and going concern.
PRINCIPLES IN FINANCIAL REPORTING
Measurement Principles
GAAP generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.
HISTORICAL COST PRINCIPLE. The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. For example, if land that was purchased for $30,000 increases in value to $40,000, it continues to be reported at $30,000.
FAIR VALUE PRINCIPLE. The fair value principle indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets. In choosing between cost and fair value, the FASB uses two qualities that make accounting information useful for decision-making—relevance and faithful representation. In determining which measurement principle to use, the FASB weighs the factual nature of cost figures versus the relevance of fair value. In general, the FASB indicates that most assets must follow the historical cost principle because market values may not be representationally faithful. Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied.
Full Disclosure Principle
The full disclosure principle requires that companies disclose all circumstances and events that would make a difference to financial statement users. If an important item cannot reasonably be reported directly in one of the four types of financial statements, then it should be discussed in notes that accompany the statements.
COST CONSTRAINT
Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard-setters consider the cost constraint. It weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.
Do it!
FINANCIAL ACCOUNTING CONCEPTS AND PRINCIPLES
The following items guide the FASB when it creates accounting standards.
Relevance
Faithful representation
Comparability
Consistency
Monetary unit assumption
Economic entity assumption
Periodicity assumption
Going concern assumption
Historical cost principle
Full disclosure principle
Materiality
Match each item above with a description below.
1. ________ |
Ability to easily evaluate one company's results relative to another's. |
2. ________ |
Belief that a company will continue to operate for the foreseeable future. |
3. ________ |
The judgment concerning whether an item is large enough to matter to decision-makers. |
| The reporting of all information that would make a difference to financial statement users. | |
5. ________ |
The practice of preparing financial statements at regular intervals. |
6. ________ |
The quality of information that indicates the information makes a difference in a decision. |
7. ________ |
A belief that items should be reported on the balance sheet at the price that was paid to acquire the item. |
8. ________ |
A company's use of the same accounting principles and methods from year to year. |
9. ________ |
Tracing accounting events to particular companies. |
10. ________ |
The desire to minimize errors and bias in financial statements. |
11. ________ |
Reporting only those things that can be measured in dollars. |
Action Plan
- Understand the need for conceptual guidelines in accounting.
- List the characteristics of useful financial information.
- Review the assumptions, principles, and constraint that comprise the guidelines in accounting.
Solution
- Comparability
- Going concern assumption
- Materiality
- Full disclosure principle
- Periodicity assumption
- Relevance
- Historical cost principle
- Consistency
- Economic entity assumption
- Faithful representation
- Monetary unit assumption
Related exercise material: BE2-8, BE2-9, BE2-10, BE2-11, 2-4, E2-12, and E2-13.
USING THE DECISION TOOLKIT
In this chapter, we evaluated a home electronics giant, Best Buy. Tweeter Home Entertainment sold consumer electronics products from 154 stores on the East Coast under various names. It specialized in products with high-end features. Tweeter filed for bankruptcy in June 2007 and was acquired by another company in July 2007. Financial data for Tweeter, prior to its bankruptcy, are provided below.
Instructions
Using the data provided, answer the following questions and discuss how these results might have provided an indication of Tweeter's financial troubles.
- Calculate the current ratio for Tweeter for 2006 and 2005 and discuss its liquidity position.
- Calculate the debt to assets ratio and free cash flow for Tweeter for 2006 and 2005 and discuss its solvency.
- Calculate the earnings per share for Tweeter for 2006 and 2005, and discuss its change in profitability.
- Best Buy's accounting year-end was February 28, 2007; Tweeter's was September 30, 2006. How does this difference affect your ability to compare their profitability?
Solution
- Current ratio:
Tweeter's liquidity improved slightly from 2005 to 2006, but in both years it would most likely have been considered inadequate. In 2006, Tweeter had only $1.37 in current assets for every dollar of current liabilities. Sometimes larger companies, such as Best Buy, can function with lower current ratios because they have alternative sources of working capital. But a company of Tweeter's size would normally want a higher ratio.
- Debt to assets:
Tweeter's solvency, as measured by its debt to assets ratio, declined from 2005 to 2006. Its ratio of 73.6% meant that every dollar of assets was financed by 73.6 cents of debt. For a retailer, this is extremely high reliance on debt. This low solvency suggests Tweeter's ability to meet its debt payments was questionable.
Free cash flow:
Tweeter's free cash flow was negative in both years. The company did not generate enough net cash provided by operating activities even to cover its capital expenditures, and it was not paying a dividend. While this is not unusual for new companies in their early years, it is also not sustainable for very long. Part of the reason that its debt to assets ratio, discussed above, was so high was that it had to borrow money to make up for its deficient free cash flow.
- Loss per share:
Tweeter's loss per share declined substantially. However, this was little consolation for its shareholders, who experienced losses in previous years as well. The company's lack of profitability, combined with its poor liquidity and solvency, increased the likelihood that it would eventually file for bankruptcy.
- Tweeter's income statement covers 7 months not covered by Best Buy's. Suppose that the economy changed dramatically during this 7-month period, either improving or declining. This change in the economy would be reflected in Tweeter's income statement but would not be reflected in Best Buy's income statement until the following March, thus reducing the usefulness of a comparison of the income statements of the two companies.
Summary of Learning Objectives
- Identify the sections of a classified balance sheet. In a classified balance sheet, companies classify assets as current assets; long-term investments; property, plant, and equipment; and intangibles. They classify liabilities as either current or long-term. A stockholders’ equity section shows common stock and retained earnings.
- Identify tools for analyzing financial statements and ratios for computing a company's profitability. Ratio analysis expresses the relationship among selected items of financial statement data. Profitability ratios, such as earnings per share (EPS), measure aspects of the operating success of a company for a given period of time.
- Explain the relationship between a retained earnings statement and a statement of stockholders’ equity. The retained earnings statement presents the factors that changed the retained earnings balance during the period. A statement of stockholders’ equity presents the factors that changed stockholders’ equity during the period, including those that changed retained earnings. Thus, a statement of stockholders’ equity is more inclusive.
- Identify and compute ratios for analyzing a company's liquidity and solvency using a balance sheet. Liquidity ratios, such as the current ratio, measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. Solvency ratios, such as the debt to assets ratio, measure the ability of a company to survive over a long period.
- Use the statement of cash flows to evaluate solvency. Free cash flow indicates a company's ability to generate net cash provided by operating activities that is sufficient to pay debts, acquire assets, and distribute dividends.
- Explain the meaning of generally accepted accounting principles. Generally accepted accounting principles are a set of rules and practices recognized as a general guide for financial reporting purposes. The basic objective of financial reporting is to provide information that is useful for decision-making.
- Discuss financial reporting concepts. To be judged useful, information should have the primary characteristics of relevance and faithful representation. In addition, useful information is comparable, consistent, verifiable, timely, and understandable.
The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption states that economic events can be identified with a particular unit of accountability. The periodicity assumption states that the economic life of a business can be divided into artificial time periods and that meaningful accounting reports can be prepared for each period. The going concern assumption states that the company will continue in operation long enough to carry out its existing objectives and commitments.
The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The full disclosure principle requires that companies disclose circumstances and events that matter to financial statement users.
The cost constraint weighs the cost that companies incur to provide a type of information against its benefit to financial statement users.
DECISION TOOLKIT A SUMMARY
Glossary
Classified balance sheet (p. 48) A balance sheet that groups together similar assets and similar liabilities, using a number of standard classifications and sections.
Comparability (p. 65) Ability to compare the accounting information of different companies because they use the same accounting principles.
Consistency (p. 65) Use of the same accounting principles and methods from year to year within a company.
Cost constraint (p. 66) Constraint that weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.
Current assets (p. 49) Assets that companies expect to convert to cash or use up within one year or the operating cycle, whichever is longer.
Current liabilities (p. 52) Obligations that a company expects to pay within the next year or operating cycle, whichever is longer.
Current ratio (p. 58) A measure of liquidity computed as current assets divided by current liabilities.
Debt to assets ratio (p. 59) A measure of solvency calculated as total liabilities divided by total assets. It measures the percentage of total financing provided by creditors.
Earnings per share (EPS) (p. 55) A measure of the net income earned on each share of common stock; computed as net income minus preferred dividends divided by the average number of common shares outstanding during the year.
Economic entity assumption (p. 65) An assumption that every economic entity can be separately identified and accounted for.
Fair value principle (p. 66) Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).
Faithful representation (p. 64) Information that is complete, neutral, and free from error.
Financial Accounting Standards Board (FASB) (p. 63) The primary accounting standard-setting body in the United States.
Free cash flow (p. 61) Net cash provided by operating activities after adjusting for capital expenditures and cash dividends paid.
Full disclosure principle (p. 66) Accounting principle that dictates that companies disclose circumstances and events that make a difference to financial statement users.
Generally accepted accounting principles (GAAP) (p. 63) A set of accounting standards that have substantial authoritative support, that guide accounting professionals.
Going concern assumption (p. 65) The assumption that the company will continue in operation for the foreseeable future.
Historical cost principle (p. 66) An accounting principle that states that companies should record assets at their cost.
Intangible assets (p. 51) Assets that do not have physical substance.
International Accounting Standards Board (IASB) (p. 63) An accounting standard-setting body that issues standards adopted by many countries outside of the United States.
International Financial Reporting Standards (IFRS) (p. 63) Accounting standards, issued by the IASB, that have been adopted by many countries outside of the United States.
Liquidity (p. 58) The ability of a company to pay obligations that are expected to become due within the next year or operating cycle.
Liquidity ratios (p. 58) Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Long-term investments (p. 50) Generally, (1) investments in stocks and bonds of other corporations that companies hold for more than one year; (2) long-term assets, such as land and buildings, not currently being used in the company's operations; and (3) long-term notes receivable.
Long-term liabilities (long-term debt) (p. 53) Obligations that a company expects to pay after one year.
Materiality (p. 64) Whether an item is large enough to likely influence the decision of an investor or creditor.
Monetary unit assumption (p. 65) An assumption that requires that only those things that can be expressed in money are included in the accounting records.
Operating cycle (p. 50) The average time required to purchase inventory, sell it on account, and then collect cash from customers—that is, go from cash to cash.
Periodicity assumption (p. 65) An assumption that the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business.
Profitability ratios (p. 55) Measures of the operating success of a company for a given period of time.
Property, plant, and equipment (p. 51) Assets with relatively long useful lives that are currently used in operating the business.
Public Company Accounting Oversight Board (PCAOB) (p. 63) The group charged with determining auditing standards and reviewing the performance of auditing firms.
Ratio (p. 54) An expression of the mathematical relationship between one quantity and another.
Ratio analysis (p. 54) A technique that expresses the relationship among selected items of financial statement data.
Relevance (p. 64) The quality of information that indicates the information makes a difference in a decision.
Securities and Exchange Commission (SEC) (p. 63) The agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies.
Solvency (p. 59) The ability of a company to pay interest as it comes due and to repay the balance of debt due at its maturity.
Solvency ratios (p. 59) Measures of the ability of the company to survive over a long period of time.
Statement of stockholders’ equity (p. 56) A financial statement that presents the causes of changes to stockholders’ equity during the period, including those that caused retained earnings to change.
Timely (p. 65) Information that is available to decision-makers before it loses its capacity to influence decisions.
Understandability (p. 65) Information presented in a clear and concise fashion so that users can interpret it and comprehend its meaning.
Verifiable (p. 65) The quality of information that occurs when independent observers, using the same methods, obtain similar results.
Working capital (p. 58) The difference between the amounts of current assets and current liabilities.
Do it! Comprehensive
Listed here are items taken from the income statement and balance sheet of Bargain Electronics, Inc. for the year ended December 31, 2014. Certain items have been combined for simplification. (Amounts are given in thousands.)
Instructions
Prepare an income statement and a classified balance sheet using the items listed. Do not use any item more than once.
Action Plan
- In preparing the income statement, list revenues, then expenses.
- In preparing a classified balance sheet, list current assets in order of liquidity.
Solution to Comprehensive
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more resources are available for practice in WileyPLUS.
Self-Test Questions
Answers are on page 95.
(LO 1)
1. In a classified balance sheet, assets are usually classified as:
(a) current assets; long-term assets; property, plant, and equipment; and intangible assets.
(b) current assets; long-term investments; property, plant, and equipment; and common stock.
(c) current assets; long-term investments; tangible assets; and intangible assets.
(d) current assets; long-term investments; property, plant, and equipment; and intangible assets.
(LO 1)
2. Current assets are listed:
(a) by order of expected conversion to cash.
(b) by importance.
(c) by longevity.
(d) alphabetically.
(LO 1)
3. The correct order of presentation in a classified balance sheet for the following current assets is:
(a) accounts receivable, cash, prepaid insurance, inventory.
(b) cash, inventory, accounts receivable, prepaid insurance.
(c) cash, accounts receivable, inventory, prepaid insurance.
(d) inventory, cash, accounts receivable, prepaid insurance.
4. A company has purchased a tract of land. It expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. The land should be reported as:
(a) property, plant, and equipment.
(b) land expense.
(c) a long-term investment.
(d) an intangible asset.
(LO 2)
5. 
Which is an indicator of profitability?
(a) Current ratio.
(b) Earnings per share.
(c) Debt to assets ratio.
(d) Free cash flow.
(LO 2)
6. For 2014, Ganos Corporation reported net income $26,000; net sales $400,000; and average shares outstanding 4,000. There were preferred dividends of $2,000. What was the 2014 earnings per share?
(a) $6.00.
(b) $6.50.
(c) $99.50.
(d) $100.00.
(LO 3)
7. The balance in retained earnings is not affected by:
(a) net income.
(b) net loss.
(c) issuance of common stock.
(d) dividends.
(LO 4)
8. Which of these measures is an evaluation of a company's ability to pay current liabilities?
(a) Earnings per share.
(b) Current ratio.
(c) Both (a) and (b).
(d) None of the above.
(LO 2, 4)
9. The following ratios are available for Bachus Inc. and Newton Inc.
Compared to Newton Inc., Bachus Inc. has:
(a) higher liquidity, higher solvency, and higher profitability.
(b) lower liquidity, higher solvency, and higher profitability.
(c) higher liquidity, lower solvency, and higher profitability.
(d) higher liquidity and lower solvency, but profitability cannot be compared based on information provided.
(LO 5)
10. Companies can use free cash flow to:
(a) pay additional dividends.
(b) acquire property, plant, and equipment.
(c) pay off debts.
(d) All of the above.
(LO 6)
11. Generally accepted accounting principles are:
(a) a set of standards and rules that are recognized as a general guide for financial reporting.
(b) usually established by the Internal Revenue Service.
(c) the guidelines used to resolve ethical dilemmas.
(d) fundamental truths that can be derived from the laws of nature.
(LO 6)
12. What organization issues U.S. accounting standards?
(a) Financial Accounting Standards Board.
(b) International Accounting Standards Committee.
(c) International Auditing Standards Committee.
(d) None of the above.
(LO 7)
13. What is the primary criterion by which accounting information can be judged?
(a) Consistency.
(b) Predictive value.
(c) Usefulness for decision-making.
(d) Comparability.
(LO 7)
14. Neutrality is an ingredient of:
(LO 7)
15. The characteristic of information that evaluates whether it is large enough to impact a decision.
(a) Comparability.
(b) Materiality.
(c) Cost.
(d) Consistency.
Go to the book's companion website, www.wiley.com/college/kimmel, to access additional Self-Test Questions.
Questions
1. What is meant by the term operating cycle?
2. Define current assets. What basis is used for ordering individual items within the current assets section?
3. Distinguish between long-term investments and property, plant, and equipment.
4. How do current liabilities differ from long-term liabilities?
5. Identify the two parts of stockholders’ equity in a corporation and indicate the purpose of each.
6.
(a) Lorie Power believes that the analysis of financial statements is directed at two characteristics of a company: liquidity and profitability. Is Lorie correct? Explain.
(b) Are short-term creditors, long-term creditors, and stockholders primarily interested in the same characteristics of a company? Explain.
7. Name ratios useful in assessing (a) liquidity, (b) solvency, and (c) profitability.
8. 
Tim Sands, the founder of Waterboots Inc., needs to raise $500,000 to expand his company's operations. He has been told that raising the money through debt will increase the riskiness of his company much more than issuing stock. He doesn't understand why this is true. Explain it to him.
9. What do these classes of ratios measure?
(a) Liquidity ratios.
(b) Profitability ratios.
(c) Solvency ratios.
10. Holding all other factors constant, indicate whether each of the following signals generally good or bad news about a company.
(a) Increase in earnings per share.
(b) Increase in the current ratio.
(c) Increase in the debt to assets ratio.
(d) Decrease in free cash flow.
11. Which ratio or ratios from this chapter do you think should be of greatest interest to:
(a) a pension fund considering investing in a corporation's 20-year bonds?
(b) a bank contemplating a short-term loan?
(c) an investor in common stock?
12.
(a) What are generally accepted accounting principles (GAAP)?
(b) What body provides authoritative support for GAAP?
13.
(a) What is the primary objective of financial reporting?
(b) Identify the characteristics of useful accounting information.
14. Joe Merando, the president of Lane Company, is pleased. Lane substantially increased its net income in 2014 while keeping its unit inventory relatively the same. Donald Jantz, chief accountant, cautions Joe, however. Jantz says that since Lane changed its method of inventory valuation, there is a consistency problem and it is difficult to determine whether Lane is better off. Is Jantz correct? Why or why not?
15. What is the distinction between comparability and consistency?
16. Describe the constraint inherent in the presentation of accounting information.
17. Your roommate believes that accounting standards are uniform throughout the world. Is your roommate correct? Explain.
18. Glenda Wine is president of Better Books. She has no accounting background. Wine cannot understand why fair value is not used as the basis for all accounting measurement and reporting. Discuss.
19. What is the economic entity assumption? Give an example of its violation.
20. 
What was Tootsie Roll's largest current asset, largest current liability, and largest item under “Other assets” at December 31, 2011?
Brief Exercises
Classify accounts on balance sheet.
(LO 1), K
BE2-1 The following are the major balance sheet classifications:
Current assets (CA)
Long-term investments (LTI)
Property, plant, and equipment (PPE)
Intangible assets (IA)
Current liabilities (CL)
Long-term liabilities (LTL)
Common stock (CS)
Retained earnings (RE)
Match each of the following accounts to its proper balance sheet classification.
_____ Accounts payable
_____ Accounts receivable
_____ Accumulated depreciation
_____ Buildings
_____ Cash
_____ Goodwill
_____ Income taxes payable
_____ Investment in long-term bonds
_____ Land
_____ Inventory
_____ Patent
_____ Supplies
Prepare the current assets section of a balance sheet.
(LO 1), AP
BE2-2 A list of financial statement items for Morales Company includes the following: accounts receivable $14,000; prepaid insurance $2,600; cash $10,400; supplies $3,800; and debt investments (short-term) $8,200. Prepare the current assets section of the balance sheet listing the items in the proper sequence.
Compute earnings per share.
(LO 2), AP
BE2-3 The following information (in millions of dollars) is available for Limited Brands for a recent year: sales revenue $9,043; net income $220; preferred dividend $0; and average shares outstanding 333 million. Compute the earnings per share for Limited Brands.
Identify items affecting stockholders’ equity.
(LO 3), K
BE2-4 For each of the following events affecting the stockholders’ equity of Noland, indicate whether the event would: increase retained earnings (IRE), decrease retained earnings (DRE), increase common stock (ICS), or decrease common stock (DCS).
| _____ (a) | Issued new shares of common stock. |
| _____ (b) | Paid a cash dividend. |
| _____ (c) | Reported net income of $75,000. |
| _____ (d) | Reported a net loss of $20,000. |
Calculate liquidity ratios.
(LO 4), AP
BE2-5 These selected condensed data are taken from a recent balance sheet of Bob Evans Farms (in millions of dollars).
Compute working capital and the current ratio.
Calculate liquidity and solvency ratios.
(LO 4, 5), AP
BE2-6 Gray's Books & Music Inc. reported the following selected information at March 31.
Calculate (a) the current ratio, (b) the debt to assets ratio, and (c) free cash flow for March 31, 2014. The company paid dividends of $12,000 and spent $24,787 on capital expenditures.
Recognize generally accepted accounting principles.
(LO 6), K
BE2-7 Indicate whether each statement is true or false.
(a) GAAP is a set of rules and practices established by accounting standard-setting bodies to serve as a general guide for financial reporting purposes.
(b) Substantial authoritative support for GAAP usually comes from two standards-setting bodies: the FASB and the IRS.
Identify characteristics of useful information.
(LO 7), K
BE2-8 The accompanying chart shows the qualitative characteristics of useful accounting information. Fill in the blanks.
Identify characteristics of useful information.
(LO 7), K
BE2-9 Given the characteristics of useful accounting information, complete each of the following statements.
(a) For information to be _____, it should have predictive and confirmatory value.
(b) _____ means that information accurately depicts what really happened.
(c) _____ means using the same accounting principles and methods from year to year within a company.
BE2-10 Here are some qualitative characteristics of useful accounting information:
- Predictive value
- Neutral
- Verifiable
- Timely
Match each qualitative characteristic to one of the following statements.
| ______ (a) | Accounting information should help provide accurate expectations about future events. |
| ______ (b) | Accounting information cannot be selected, prepared, or presented to favor one set of interested users over another. |
| ______ (c) | The quality of information that occurs when independent observers, using the same methods, obtain similar results. |
| ______ (d) | Accounting information must be available to decision-makers before it loses its capacity to influence their decisions. |
Define full disclosure principle.
(LO 7), K
BE2-11 The full disclosure principle dictates that:
(a) financial statements should disclose all assets at their cost.
(b) financial statements should disclose only those events that can be measured in dollars.
(c) financial statements should disclose all events and circumstances that would matter to users of financial statements.
(d) financial statements should not be relied on unless an auditor has expressed an unqualified opinion on them.
Do it! Review
Prepare assets section of balance sheet.
(LO 1), AP
2-1 Lonyear Corporation has collected the following information related to its December 31, 2014, balance sheet.
Prepare the assets section of Lonyear Corporation's balance sheet.
Classify financial statement items by balance sheet classification.
(LO 1), AP
2-2 The following financial statement items were taken from the financial statements of Zheng Corp.
| ____ Trademarks | ____ Inventory |
| ____ Notes payable (current) | ____ Accumulated depreciation |
| ____ Interest revenue | ____ Land |
| ____ Income taxes payable | ____ Common stock |
| ____ Debt investments (long-term) | ____ Advertising expense |
| ____ Unearned sales revenue | ____ Mortgage payable (due in 3 years) |
Match each of the financial statement items to its proper balance sheet classification. (See E2-1, on page 77, for a list of the balance sheet classifications.) If the item would not appear on a balance sheet, use “NA.”
Compute ratios and analyze.
(LO 4, 5), AP
2-3 The following information is available for Benser Corporation.
(a) Compute earnings per share for 2014 and 2013 for Benser, and comment on the change. Benser's primary competitor, Matile Corporation, had earnings per share of $1 per share in 2014. Comment on the difference in the ratios of the two companies.
(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.
(c) Compute free cash flow for each year, and comment on the changes.
Identify financial accounting concepts and principles.
(LO 7), K
2-4 The following characteristics, assumptions, principles, and constraint guide the FASB when it creates accounting standards.
Relevance
Faithful representation
Comparability
Consistency
Monetary unit assumption
Economic entity assumption
Periodicity assumption
Going concern assumption
Historical cost principle
Full disclosure principle
Materiality
Cost constraint
Match each item above with a description below.
1. __________ |
Items not easily quantified in dollar terms are not reported in the financial statements. |
2. __________ |
Accounting information must be complete, neutral, and free from error. |
3. __________ |
Personal transactions are not mixed with the company's transactions. |
4. __________ |
The cost to provide information should be weighed against the benefit that users will gain from having the information available. |
5. __________ |
A company's use of the same accounting principles from year to year. |
6. __________ |
Assets are recorded and reported at original purchase price. |
7. __________ |
Accounting information should help users predict future events, and should confirm or correct prior expectations. |
8. __________ |
The life of a business can be divided into artificial segments of time. |
9. __________ |
The reporting of all information that would make a difference to financial statement users. |
10. __________ |
The judgment concerning whether an item's size makes it likely to influence a decision-maker. |
11. __________ |
Assumes a business will remain in operation for the foreseeable future. |
12. __________ |
Different companies use the same accounting principles. |
Exercises
Classify accounts on balance sheet.
(LO 1), AP
E2-1 The following are the major balance sheet classifications.
Current assets (CA)
Long-term investments (LTI)
Property, plant, and equipment (PPE)
Intangible assets (IA)
Current liabilities (CL)
Long-term liabilities (LTL)
Stockholders’ equity (SE)
Instructions
Classify each of the following financial statement items taken from Mordica Corporation's balance sheet.
____ Accounts payable
____ Accounts receivable
____ Accumulated depreciation—equipment
____ Buildings
____ Cash
____ Interest payable
____ Goodwill
____ Income taxes payable
____ Inventory
____ Stock investments (to be sold in 7 months)
____ Land (in use)
____ Mortgage payable
____ Supplies
____ Equipment
____ Prepaid rent
E2-2 The major balance sheet classifications are listed in E2-1.
Instructions
Classify each of the following financial statement items based upon the major balance sheet classifications listed in E2-1.
____ Prepaid advertising
____ Equipment
____ Trademarks
____ Salaries and wages payable
____ Income taxes payable
____ Retained earnings
____ Accounts receivable
____ Land (held for future use)
____ Patents
____ Bonds payable
____ Common stock
____ Accumulated depreciation—equipment
____ Unearned sales revenue
____ Inventory
Classify items as current or noncurrent, and prepare assets section of balance sheet.
(LO 1), AP
E2-3 Suppose the following items were taken from the December 31, 2014, assets section of the Boeing Company balance sheet. (All dollars are in millions.)
Instructions
Prepare the assets section of a classified balance sheet, listing the current assets in order of their liquidity.
Prepare assets section of a classified balance sheet.
(LO 1), AP
E2-4 Suppose the following information (in thousands of dollars) is available for H.J. Heinz Company—famous for ketchup and other fine food products—for the year ended April 30, 2014.
Instructions
Prepare the assets section of a classified balance sheet, listing the items in proper sequence and including a statement heading.
Prepare a classified balance sheet.
(LO 1), AP
E2-5 These items are taken from the financial statements of Donavan Co. at December 31, 2014.
Prepare a classified balance sheet. Assume that $13,600 of the note payable will be paid in 2015.
Prepare a classified balance sheet.
(LO 1), AP
E2-6 Suppose the following items were taken from the 2014 financial statements of Texas Instruments, Inc. (All dollars are in millions.)
Instructions
Prepare a classified balance sheet in good form as of December 31, 2014.
Compute and interpret profitability ratio.
(LO 2), AP
E2-7 Suppose the following information is available for Callaway Golf Company for the years 2014 and 2013. (Dollars are in thousands, except share information.)
There were 73,139,000 shares outstanding at the end of 2012.
Instructions
(a) What was the company's earnings per share for each year?
(b) Based on your findings above, how did the company's profitability change from 2013 to 2014?
(c) Suppose the company had paid dividends on preferred stock and on common stock during the year. How would this affect your calculation in part (a)?
Prepare financial statements.
(LO 1, 3, 4), AP
E2-8 These financial statement items are for Barfield Corporation at year-end, July 31, 2014.
Instructions
(a) Prepare an income statement and a retained earnings statement for the year. Barfield Corporation did not issue any new stock during the year.
(b) Prepare a classified balance sheet at July 31.
(c) Compute the current ratio and debt to assets ratio.
(d) Suppose that you are the president of Crescent Equipment. Your sales manager has approached you with a proposal to sell $20,000 of equipment to Barfield. He would like to provide a loan to Barfield in the form of a 10%, 5-year note payable. Evaluate how this loan would change Barfield's current ratio and debt to assets ratio, and discuss whether you would make the sale.
Compute liquidity ratios and compare results.
(LO 4), AP
E2-9 Nordstrom, Inc. operates department stores in numerous states. Selected financial statement data (in millions of dollars) for a recent year follow.
Instructions
(a) Compute working capital and the current ratio at the beginning of the year and at the end of the year.
(b) Did Nordstrom's liquidity improve or worsen during the year?
(c) Using the data in the chapter, compare Nordstrom's liquidity with Best Buy's (see page 57).
Compute liquidity measures and discuss findings.
(LO 4), AP
E2-10 The chief financial officer (CFO) of Grienke Corporation requested that the accounting department prepare a preliminary balance sheet on December 30, 2014, so that the CFO could get an idea of how the company stood. He knows that certain debt agreements with its creditors require the company to maintain a current ratio of at least 2:1. The preliminary balance sheet is as follows.
Instructions
(a) Calculate the current ratio and working capital based on the preliminary balance sheet.
(b) Based on the results in (a), the CFO requested that $20,000 of cash be used to pay off the balance of the accounts payable account on December 31, 2014. Calculate the new current ratio and working capital after the company takes these actions.
(c) Discuss the pros and cons of the current ratio and working capital as measures of liquidity.
(d) Was it unethical for the CFO to take these steps?
E2-11 Suppose the following data were taken from the 2014 and 2013 financial statements of American Eagle Outfitters. (All dollars are in thousands.)
Instructions
Perform each of the following.
(a) Calculate the current ratio for each year.
(b) Calculate earnings per share for each year.
(c) Calculate the debt to assets ratio for each year.
(d) Calculate the free cash flow for each year.
(e) Discuss American Eagle's solvency in 2014 versus 2013.
(f) Discuss American Eagle's ability to finance its investment activities with net cash provided by operating activities, and how any deficiency would be met.
Identify accounting assumptions and principles.
(LO 7), K
E2-12 Presented below are the assumptions and principles discussed in this chapter.
- Full disclosure principle.
- Going concern assumption.
- Monetary unit assumption.
- Periodicity assumption.
- Historical cost principle.
- Economic entity assumption.
Instructions
Identify by number the accounting assumption or principle that is described below. Do not use a number more than once.
| ______ (a) | Is the rationale for why plant assets are not reported at liquidation value. (Note: Do not use the historical cost principle.) |
| ______ (b) | Indicates that personal and business record-keeping should be separately maintained. |
| ______ (c) | Assumes that the dollar is the “measuring stick” used to report on financial performance. |
| ______ (d) | Separates financial information into time periods for reporting purposes. |
| ______ (e) | Measurement basis used when a reliable estimate of fair value is not available. |
| ______ (f) | Dictates that companies should disclose all circumstances and events that make a difference to financial statement users. |
Identify the assumption or principle that has been violated.
(LO 7), C
E2-13 Garcia Co. had three major business transactions during 2014.
(a) Reported at its fair value of $260,000 merchandise inventory with a cost of $208,000.
(b) The president of Garcia Co., Sal Garcia, purchased a truck for personal use and charged it to his expense account.
(c) Garcia Co. wanted to make its 2014 income look better, so it added 2 more weeks to the year (a 54-week year). Previous years were 52 weeks.
Instructions
In each situation, identify the assumption or principle that has been violated, if any, and discuss what the company should have done.
Exercises: Set B and Challenge Exercises
Visit the book's companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercise Set B and Challenge Exercises.
Problems: Set A
P2-1A Suppose the following items are taken from the 2014 balance sheet of Yahoo! Inc. (All dollars are in millions.)
Instructions
Prepare a classified balance sheet for Yahoo! Inc. as of December 31, 2014.
Prepare financial statements.
(LO 1, 3), AP
P2-2A These items are taken from the financial statements of Tresh Corporation for 2014.
Instructions
Prepare an income statement, a retained earnings statement, and a classified balance sheet as of December 31, 2014.
Prepare financial statements.
(LO 1, 3), AP
P2-3A You are provided with the following information for Ramirez Enterprises, effective as of its April 30, 2014, year-end.
Instructions
(a) Prepare an income statement and a retained earnings statement for Ramirez Enterprises for the year ended April 30, 2014.
(b) Prepare a classified balance sheet for Ramirez Enterprises as of April 30, 2014.
Compute ratios; comment on relative profitability, liquidity, and solvency.
(LO 2, 4, 5), AN
P2-4A Comparative financial statement data for Bosch Corporation and Fielder Corporation, two competitors, appear below. All balance sheet data are as of December 31, 2014.
Instructions
(a) Comment on the relative profitability of the companies by computing the net income and earnings per share for each company for 2014.
(b) Comment on the relative liquidity of the companies by computing working capital and the current ratio for each company for 2014.
(c) Comment on the relative solvency of the companies by computing the debt to assets ratio and the free cash flow for each company for 2014.
Compute and interpret liquidity, solvency, and profitability ratios.
(LO 2, 4, 5), AP
P2-5A Here and on page 84 are financial statements of Ogleby Company.
Additional information: The net cash provided by operating activities for 2014 was $190,800. The cash used for capital expenditures was $92,000. The cash used for dividends was $31,000. The average number of shares outstanding during the year was 50,000.
Instructions
(a) Compute the following values and ratios for 2014. (We provide the results from 2013 for comparative purposes.)
(i) Working capital. (2013: $160,500)
(ii) Current ratio. (2013: 1.65:1)
(iii) Free cash flow. (2013: $48,700)
(iv) Debt to assets ratio. (2013: 31%)
(v) Earnings per share. (2013: $3.15)
(b) Using your calculations from part (a), discuss changes from 2013 in liquidity, solvency, and profitability.
Compute and interpret liquidity, solvency, and profitability ratios.
(LO 2, 4, 5), AP
P2-6A Condensed balance sheet and income statement data for Sadecki Corporation are presented here and on the next page.
Instructions
Compute these values and ratios for 2013 and 2014.
(a) Earnings per share.
(b) Working capital.
(c) Current ratio.
(d) Debt to assets ratio.
(e) Free cash flow.
(f) 
Based on the ratios calculated, discuss briefly the improvement or lack thereof in financial position and operating results from 2013 to 2014 of Sadecki Corporation.
Compute ratios and compare liquidity, solvency, and profitability for two companies.
(LO 2, 4, 5), AP
P2-7A Selected financial data of two competitors, Target and Wal-Mart, are presented here. (All dollars are in millions.) Suppose the data were taken from the 2014 financial statements of each company.
Instructions
For each company, compute these values and ratios.
(a) Working capital.
(b) Current ratio.
(c) Debt to assets ratio.
(d) Free cash flow.
(e) Earnings per share.
(f) Compare the liquidity and solvency of the two companies.
Comment on the objectives and qualitative characteristics of financial reporting.
(LO 6, 7), E
P2-8A A friend of yours, Sue Yaeger, recently completed an undergraduate degree in science and has just started working with a biotechnology company. Sue tells you that the owners of the business are trying to secure new sources of financing which are needed in order for the company to proceed with development of a new health care product. Sue said that her boss told her that the company must put together a report to present to potential investors.
Sue thought that the company should include in this package the detailed scientific findings related to the Phase I clinical trials for this product. She said, “I know that the biotech industry sometimes has only a 10% success rate with new products, but if we report all the scientific findings, everyone will see what a sure success this is going to be! The president was talking about the importance of following some set of accounting principles. Why do we need to look at some accounting rules? What they need to realize is that we have scientific results that are quite encouraging, some of the most talented employees around, and the start of some really great customer relationships. We haven't made any sales yet, but we will. We just need the funds to get through all the clinical testing and get government approval for our product. Then these investors will be quite happy that they bought in to our company early!”
Instructions
(a) What is accounting information? Explain to Sue what is meant by generally accepted accounting principles.
(b) Comment on how Sue's suggestions for what should be reported to prospective investors conforms to the qualitative characteristics of accounting information. Do you think that the things that Sue wants to include in the information for investors will conform to financial reporting guidelines?
Problems: Set B
Prepare a classified balance sheet.
(LO 1), AP
P2-1B Suppose the following items are taken from the 2014 balance sheet of Starbucks Corporation. (All dollars are in millions.)
Instructions
Prepare a classified balance sheet for Starbucks Corporation as of September 30, 2014.
Prepare financial statements.
(LO 1, 3), AP
P2-2B These items are taken from the financial statements of Mueller, Inc.
Instructions
Prepare an income statement, a retained earnings statement, and a classified balance sheet as of December 31, 2014.
Prepare financial statements.
(LO 1, 3), AP
P2-3B You are provided with the following information for Vern Corporation, effective as of its April 30, 2014, year-end.
Instructions
(a) Prepare an income statement and a retained earnings statement for Vern Corporation for the year ended April 30, 2014.
(b) Prepare a classified balance sheet for Vern as of April 30, 2014.
Compute ratios; comment on relative profitability, liquidity, and solvency.
(LO 2, 4, 5), AN
P2-4B Comparative statement data for Omaz Company and Wise Company, two competitors, are presented below. All balance sheet data are as of December 31, 2014.
Instructions
(a) Compute the net income and earnings per share for each company for 2014.
(b) Comment on the relative liquidity of the companies by computing working capital and the current ratio for each company for 2014.
(c) Comment on the relative solvency of the companies by computing the debt to assets ratio and the free cash flow for each company for 2014.
P2-5B The financial statements of Divine Company are presented here.
Instructions
(a) Compute the following values and ratios for 2014. (We provide the results from 2013 for comparative purposes.)
(i) Current ratio. (2013: 2.4:1)
(ii) Working capital. (2013: $178,000)
(iii) Debt to assets ratio. (2013: 31%)
(iv) Free cash flow. (2013: $13,000)
(v) Earnings per share. (2013: $1.35)
(b) Using your calculations from part (a), discuss changes from 2013 in liquidity, solvency, and profitability.
P2-6B Condensed balance sheet and income statement data for Fellini Corporation are presented below.
Instructions
Compute the following values and ratios for 2013 and 2014.
(a) Earnings per share.
(b) Working capital.
(c) Current ratio.
(d) Debt to assets ratio.
(e) Free cash flow.
(f) Based on the ratios calculated, discuss briefly the improvement or lack thereof in the financial position and operating results of Fellini from 2013 to 2014.
Compute ratios and compare liquidity, solvency, and profitability for two companies.
(LO 2, 4, 5), AP
P2-7B Selected financial data of two competitors, Home Depot and Lowe's, are presented here. (All dollars are in millions.) Suppose the data were taken from the 2014 financial statements of each company.
Instructions
For each company, compute these values and ratios.
(a) Working capital.
(b) Current ratio. (Round to two decimal places.)
(c) Debt to assets ratio.
(d) Free cash flow.
(e) Earnings per share.
(f) Compare the liquidity, profitability, and solvency of the two companies.
Comment on the objectives and qualitative characteristics of accounting information.
(LO 6, 7), E
P2-8B Yocum Software International Inc., headquartered in Toronto, specializes in Internet safety and computer security products for both the home and commercial markets. In a recent balance sheet, it reported a deficit (negative retained earnings) of US$5,678,288. It has reported only net losses since its inception. In spite of these losses, Yocum's common shares have traded anywhere from a high of $3.70 to a low of $0.32 on the Canadian Venture Exchange.
Yocum's financial statements have historically been prepared in Canadian dollars. Recently, the company adopted the U.S. dollar as its reporting currency.
Instructions
(a) What is the objective of financial reporting? How does this objective meet or not meet Yocum's investors’ needs?
(b) Why would investors want to buy Yocum's shares if the company has consistently reported losses over the last few years? Include in your answer an assessment of the relevance of the information reported on Yocum's financial statements.
(c) Comment on how the change in reporting information from Canadian dollars to U.S. dollars likely affected the readers of Yocum's financial statements. Include in your answer an assessment of the comparability of the information.
Problems: Set C
Visit the book's companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problem Set C.
Continuing Cookie Chronicle
(Note: This is a continuation of the Cookie Chronicle from Chapter 1.)
CCC2 After investigating the different forms of business organization, Natalie Koebel decides to operate her business as a corporation, Cookie Creations Inc., and she begins the process of getting her business running.
While at a trade show, Natalie is introduced to Gerry Richards, operations manager of “Biscuits,” a national food retailer. After much discussion, Gerry asks Natalie to consider being Biscuits’ major supplier of oatmeal chocolate chip cookies. He provides Natalie with the most recent copy of the financial statements of Biscuits. He expects that Natalie will need to supply Biscuits’ Watertown warehouse with approximately 1,500 dozen cookies a week. Natalie is to send Biscuits a monthly invoice, and she will be paid approximately 30 days from the date the invoice is received in Biscuits’ Chicago office.
Natalie is thrilled with the offer. However, she has recently read in the newspaper that Biscuits has a reputation for selling cookies and donuts with high amounts of sugar and fat, and as a result, consumer demand for the company's products has decreased.
Instructions
Natalie has several questions. Answer the following questions for Natalie.
(a) What type of information does each financial statement provide?
(b) What financial statements would Natalie need in order to evaluate whether Biscuits will have enough cash to meet its current liabilities? Explain what to look for.
(c) What financial statements would Natalie need in order to evaluate whether Biscuits will be able to survive over a long period of time? Explain what to look for.
(d) What financial statement would Natalie need in order to evaluate Biscuits’ profitability? Explain what to look for.
(e) Where can Natalie find out whether Biscuits has outstanding debt? How can Natalie determine whether Biscuits would be able to meet its interest and debt payments on any debts it has?
(f) How could Natalie determine whether Biscuits pays a dividend?
(g) In deciding whether to go ahead with this opportunity, are there other areas of concern that Natalie should be aware of?
Broadening Your Perspective
Financial Reporting and Analysis
FINANCIAL REPORTING PROBLEM: Tootsie Roll Industries, Inc.
BYP2-1 The financial statements of Tootsie Roll Industries, Inc., appear in Appendix A at the end of this textbook.
Instructions
Answer the following questions using the financial statements and the notes to the financial statements.
(a) What were Tootsie Roll's total current assets at December 31, 2011, and December 31, 2010?
(b) Are the assets included in current assets listed in the proper order? Explain.
(c) How are Tootsie Roll's assets classified?
(d) What were Tootsie Roll's current liabilities at December 31, 2011, and December 31, 2010?
COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Hershey
BYP2-2 The financial statements of The Hershey Company appear in Appendix B, following the financial statements for Tootsie Roll in Appendix A. Assume Hershey's average number of shares outstanding was 227,514,000, and Tootsie Roll's was 56,997,000.
Instructions
(a) For each company calculate the following values for 2011.
(1) Working capital.
(2) Current ratio.
(3) Debt to assets ratio.
(4) Free cash flow.
(5) Earnings per share.
(Hint: When calculating free cash flow, do not consider business acquisitions to be part of capital expenditures.)
(b) Based on your findings above, discuss the relative liquidity and solvency of the two companies.
RESEARCH CASE
BYP2-3 The July 6, 2011, edition of the Wall Street Journal Online includes an article by Michael Rapoport entitled “U.S. Firms Clash Over Accounting Rules.” The article discusses why some U.S. companies favored adoption of International Financial Reporting Standards (IFRS) while other companies opposed it.
Instructions
Read the article and answer the following questions.
(a) The articles says that the switch to IFRS tends to be favored by “larger companies, big accounting firms, and rule makers.” What reasons are given for favoring the switch?
(b) What two reasons are given by many smaller companies that oppose the switch?
(c) What criticism of IFRS is raised with regard to regulated companies?
(d) Explain what is meant by “condorsement.”
INTERPRETING FINANCIAL STATEMENTS
BYP2-4 The following information was reported by Gap, Inc. in its 2010 annual report.
(a) Determine the overall percentage decrease in Gap's total assets from 2006 to 2010. What was the average decrease per year?
(b) Comment on the change in Gap's liquidity. Does working capital or the current ratio appear to provide a better indication of Gap's liquidity? What might explain the change in Gap's liquidity during this period?
(c) Comment on the change in Gap's solvency during this period.
(d) Comment on the change in Gap's profitability during this period. How might this affect your prediction about Gap's future profitability?
REAL-WORLD FOCUS
BYP2-5 Purpose: Identify summary liquidity, solvency, and profitability information about companies, and compare this information across companies in the same industry.
Address: http://biz.yahoo.com/i, or go to www.wiley.com/college/kimmel
Steps
- Type in a company name, or use the index to find a company name. Choose Profile. Choose Key Statistics. Perform instruction (a) below.
- Go back to Profile. Click on the company's particular industry behind the heading “Industry.” Perform instructions (b), (c), and (d).
Instructions
Answer the following questions.
(a) What is the company's name? What was the company's current ratio and debt to equity ratio (a variation of the debt to assets ratio)?
(b) What is the company's industry?
(c) What is the name of a competitor? What is the competitor's current ratio and its debt to equity ratio?
(d) Based on these measures, which company is more liquid? Which company is more solvent?
BYP2-6 The Feature Story described the dramatic effect that investment bulletin boards are having on the investment world. This exercise will allow you to evaluate a bulletin board discussing a company of your choice.
Address: http://biz.yahoo.com/i, or go to www.wiley.com/college/kimmel
- Type in a company name, or use the index to find a company name.
- Choose Msgs or Message Board. (for messages).
- Read the 10 most recent messages.
Instructions
Answer the following questions.
(a) State the nature of each of these messages (e.g., offering advice, criticizing company, predicting future results, ridiculing other people who have posted messages).
(b) For those messages that expressed an opinion about the company, was evidence provided to support the opinion?
(c) What effect do you think it would have on bulletin board discussions if the participants provided their actual names? Do you think this would be a good policy?
Critical Thinking
DECISION-MAKING ACROSS THE ORGANIZATION
BYP2-7 As a financial analyst in the planning department for Shonrock Industries, Inc., you have been requested to develop some key ratios from the comparative financial statements. This information is to be used to convince creditors that Shonrock Industries, Inc. is liquid, solvent, and profitable, and that it deserves their continued support. Lenders are particularly concerned about the company's ability to continue as a going concern.
Here are the data requested and the computations developed from the financial statements:
Instructions
Shonrock Industries, Inc. asks you to prepare brief comments stating how each of these items supports the argument that its financial health is improving. The company wishes to use these comments to support presentation of data to its creditors. With the class divided into groups, prepare the comments as requested, giving the implications and the limitations of each item regarding Shonrock's financial well-being.
COMMUNICATION ACTIVITY
BYP2-8 F. P. Fernetti is the chief executive officer of Tomorrow's Products. Fernetti is an expert engineer but a novice in accounting.
Instructions
Write a letter to F. P. Fernetti that explains (a) the three main types of ratios; (b) examples of each, how they are calculated, and what they measure; and (c) the bases for comparison in analyzing Tomorrow's Products’ financial statements.
ETHICS CASE
BYP2-9 At one time, Boeing closed a giant deal to acquire another manufacturer, McDonnell Douglas. Boeing paid for the acquisition by issuing shares of its own stock to the stockholders of McDonnell Douglas. In order for the deal not to be revoked, the value of Boeing's stock could not decline below a certain level for a number of months after the deal.
During the first half of the year, Boeing suffered significant cost overruns because of inefficiencies in its production methods. Had these problems been disclosed in the quarterly financial statements during the first and second quarters of the year, the company's stock most likely would have plummeted, and the deal would have been revoked. Company managers spent considerable time debating when the bad news should be disclosed. One public relations manager suggested that the company's problems be revealed on the date of either Princess Diana's or Mother Teresa's funeral, in the hope that it would be lost among those big stories that day. Instead, the company waited until October 22 of that year to announce a $2.6 billion write-off due to cost overruns. Within one week, the company's stock price had fallen 20%, but by this time the McDonnell Douglas deal could not be reversed.
Instructions
Answer the following questions.
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues?
(c) What assumptions or principles of accounting are relevant to this case?
(d) Do you think it is ethical to try to “time” the release of a story so as to diminish its effect?
(e) What would you have done if you were the chief executive officer of Boeing?
(f) Boeing's top management maintains that it did not have an obligation to reveal its problems during the first half of the year. What implications does this have for investors and analysts who follow Boeing's stock?
ALL ABOUT YOU
BYP2-10 Every company needs to plan in order to move forward. Its top management must consider where it wants the company to be in three to five years. Like a company, you need to think about where you want to be three to five years from now, and you need to start taking steps now in order to get there.
Instructions
Provide responses to each of the following items.
(a) Where would you like to be working in three to five years? Describe your plan for getting there by identifying between five and 10 specific steps that you need to take in order to get there.
(b) In order to get the job you want, you will need a résumé. Your résumé is the equivalent of a company's annual report. It needs to provide relevant and reliable information about your past accomplishments so that employers can decide whether to “invest” in you. Do a search on the Internet to find a good résumé format. What are the basic elements of a résumé?
(c) A company's annual report provides information about a company's accomplishments. In order for investors to use the annual report, the information must be reliable; that is, users must have faith that the information is accurate and believable. How can you provide assurance that the information on your résumé is reliable?
(d) Prepare a résumé assuming that you have accomplished the five to 10 specific steps you identified in part (a). Also, provide evidence that would give assurance that the information is reliable.
FASB CODIFICATION ACTIVITY
BYP2-11 If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following.
Instructions
(a) Access the glossary (“Master Glossary”) at the FASB Codification website to answer the following.
(1) What is the definition of current assets?
(2) What is the definition of current liabilities?
(b) A company wants to offset its accounts payable against its cash account and show a cash amount net of accounts payable on its balance sheet. Identify the criteria (found in the FASB Codification) under which a company has the right of set off. Does the company have the right to offset accounts payable against the cash account?
CONSIDERING PEOPLE, PLANET, AND PROFIT
BYP2-12 Auditors provide a type of certification of corporate financial statements. Certification is used in many other aspects of business as well. For example, it plays a critical role in the sustainability movement. The February 7, 2012, issue of the New York Times contained an article by S. Amanda Caudill entitled “Better Lives in Better Coffee,” which discusses the role of certification in the coffee business.
Address: http://scientistatwork.blogs.nytimes.com/2012/02/07/better-lives-in-better-coffee/
Instructions
Read the article and answer the following questions.
(a) The article mentions three different certification types that coffee growers can obtain from three different certification bodies. Using financial reporting as an example, what potential problems might the existence of multiple certification types present to coffee purchasers?
(b) According to the author, which certification is most common among coffee growers? What are the possible reasons for this?
(c) What social and environmental benefits are coffee certifications trying to achieve? Are there also potential financial benefits to the parties involved?
Answers to Insight and Accounting Across the Organization Questions
p. 59 Can a Company Be Too Liquid? Q: What can various company managers do to ensure that working capital is managed efficiently to maximize net income? A: Marketing and sales managers must understand that by extending generous repayment terms, they are expanding the company's receivables balance and slowing the company's cash flow. Production managers must strive to minimize the amount of excess inventory on hand. Managers must coordinate efforts to speed up the collection of receivables, while also ensuring that the company pays its payables on time but never too early.
p. 60 When Debt Is Good Q: Discuss the difference in the debt to assets ratio of Microsoft and General Motors. A: Microsoft has a very low debt to assets ratio. The company is in a rapidly changing industry and thus should try to minimize the risk associated with increased debt. Also, because Microsoft generates significant amounts of cash and has minimal needs for large investments in plant assets, it does not need to borrow a lot of cash. General Motors needs to make huge investments in plant assets, and it has a very large credit operation. Thus, it has large borrowing needs.
p. 63 The Korean Discount Q: What is meant by the phrase “make the country's businesses more transparent”? Why would increasing transparency spur economic growth? A: Transparency refers to the extent to which outsiders have knowledge regarding a company's financial performance and financial position. If a company lacks transparency, its financial reports do not adequately inform investors of critical information that is needed to make investment decisions. If corporate transparency is increased, investors will be more willing to supply the financial capital that businesses need in order to grow, which would spur the country's economic growth.
p. 64 What Do These Companies Have in Common? Q: What problems might Best Buy's year-end create for analysts? A: First, if Best Buy's competitors use a different year-end, then when you compare their financial results, you are not comparing performance over the same period of time or financial position at the same point in time. Also, by not picking a particular date, the number of weeks in Best Buy's fiscal year will change. For example, fiscal years 2008 and 2009 had 52 weeks, but fiscal year 2007 had 53 weeks.
Answers to Self-Test Questions
- d
- a
- c
- c
- b
- a ($26,000 − $4,000)
- c
- b
- d
- d
- a
- a
- c
- c
- b
A Look at IFRS
LEARNING OBJECTIVE 8
Compare the classified balance sheet format under GAAP and IFRS.
The classified balance sheet, although generally required internationally, contains certain variations in format when reporting under IFRS.
KEY POINTS
- IFRS recommends but does not require the use of the title “statement of financial position” rather than balance sheet.
- The format of statement of financial position information is often presented differently under IFRS. Although no specific format is required, most companies that follow IFRS present statement of financial position information in this order:
- Noncurrent assets
- Current assets
- Equity
- Noncurrent liabilities
- Current liabilities
- IFRS requires a classified statement of financial position except in very limited situations. IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities.
- Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last.
- Some companies report the subtotal net assets, which equals total assets minus total liabilities. See, for example, the statement of financial position of Zetar in Appendix C.
- IFRS has many differences in terminology that you will notice in this textbook. For example, in the sample statement of financial position illustrated below, notice in the investment category that stock is called shares, and in the equity section common stock is called share capital—ordinary.
- Both IFRS and GAAP require disclosures about (1) accounting policies followed, (2) judgments that management has made in the process of applying the entity's accounting policies, and (3) the key assumptions and estimation uncertainty that could result in a material adjustment to the carrying amounts of assets and liabilities within the next financial year.
- Comparative prior period information must be presented and financial statements must be prepared annually.
- Both GAAP and IFRS are increasing the use of fair value to report assets. However, at this point IFRS has adopted it more broadly. As examples, under IFRS companies can apply fair value to property, plant, and equipment; natural resources; and in some cases intangible assets.
- Recently, the IASB and FASB completed the first phase of a jointly created conceptual framework. In this first phase, they agreed on the objective of financial reporting and a common set of desired qualitative characteristics. These were presented in the Chapter 2 discussion.
- The monetary unit assumption is part of each framework. However, the unit of measure will vary depending on the currency used in the country in which the company is incorporated (e.g., Chinese yuan, Japanese yen, and British pound).
- The economic entity assumption is also part of each framework, although some cultural differences result in differences in its application. For example, in Japan many companies have formed alliances that are so strong that they act similar to related corporate divisions, although they are not actually part of the same company.
LOOKING TO THE FUTURE
The IASB and the FASB are working on a project to converge their standards related to financial statement presentation. A key feature of the proposed framework is that each of the statements will be organized in the same format, to separate an entity's financing activities from its operating and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the income statement and the statement of cash flows. The project has three phases. You can follow the joint financial presentation project at the following link: http://www.fasb.org/project/financial_statement_presentation.shtml.
The IASB and the FASB face a difficult task in attempting to update, modify, and complete a converged conceptual framework. For example, how do companies choose between information that is highly relevant but difficult to verify versus information that is less relevant but easy to verify? How do companies define control when developing a definition of an asset? Is a liability the future sacrifice itself or the obligation to make the sacrifice? Should a single measurement method, such as historical cost or fair value, be used, or does it depend on whether it is an asset or liability that is being measured? It appears that the new document will be a significant improvement over its predecessors and will lead to principle-based standards, which will help financial statement users make better decisions.
IFRS PRACTICE
IFRS SELF-TEST QUESTIONS
- Which of the following statements is false?
(a) The monetary unit assumption is used under IFRS.
(b) Under IFRS, companies sometimes net liabilities against assets to report “net assets.”
(c) The FASB and IASB are working on a joint conceptual framework project.
(d) Under IFRS, the statement of financial position is usually referred to as the statement of assets and equity.
- A company has purchased a tract of land and expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. Under IFRS, the land should be reported as:
(a) land expense.
(b) property, plant, and equipment.
(c) an intangible asset.
(d) a long-term investment.
- Current assets under IFRS are listed generally:
(a) by importance.
(b) in the reverse order of their expected conversion to cash.
(c) by longevity.
(d) alphabetically.
- Companies that use IFRS:
(a) may report all their assets on the statement of financial position at fair value.
(b) may offset assets against liabilities and show net assets and net liabilities on their statement of financial positions, rather than the underlying detailed line items.
(c) may report noncurrent assets before current assets on the statement of financial position.
(d) do not have any guidelines as to what should be reported on the statement of financial position.
- Companies that follow IFRS to prepare a statement of financial position generally use the following order of classification:
(a) current assets, current liabilities, noncurrent assets, noncurrent liabilities, equity.
(b) noncurrent assets, noncurrent liabilities, current assets, current liabilities, equity.
(c) noncurrent assets, current assets, equity, noncurrent liabilities, current liabilities.
(d) equity, noncurrent assets, current assets, noncurrent liabilities, current liabilities.
IFRS CONCEPTS AND APPLICATION
IFRS2-1 In what ways does the format of a statement of financial of position under IFRS often differ from a balance sheet presented under GAAP?
IFRS2-2 Do the IFRS and GAAP conceptual frameworks differ in terms of the objective of financial reporting? Explain.
IFRS2-3 What terms commonly used under IFRS are synonymous with common stock and balance sheet?
IFRS2-4 The statement of financial position for Ruiz Company includes the following accounts (in British pounds): Accounts Receivable £12,500; Prepaid Insurance £3,600; Cash £15,400; Supplies £5,200; and Debt Investments (short-term) £6,700. Prepare the current assets section of the statement of financial position, listing the accounts in proper sequence.
IFRS2-5 Widmer Company recently received the following information related to the company's December 31, 2014, statement of financial position (in Swiss francs).
Prepare the assets section of the company's classified statement of financial position.
IFRS2-6 The following information is available for Cole Bowling Alley at December 31, 2014.
Prepare a classified statement of financial position; assume that $13,900 of the notes payable will be paid in 2015.
IFRS2-7 Steve Trevino is interested in comparing the liquidity and solvency of a U.S. software company with a Chinese competitor. Is this possible if the two companies report using different currencies?
INTERNATIONAL COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Zetar plc
IFRS2-8 The financial statements of Zetar plc are presented in Appendix C. The company's complete annual report, including the notes to its financial statements, is available in the Investors section at www.zetarplc.com.
Instructions
Identify five differences in the format of the statement of financial position used by Zetar compared to a company, such as Tootsie Roll, that follows GAAP. (Tootsie Roll's financial statements are available in Appendix A.)
Answers to IFRS Self-Test Questions
- d
- d
- b
- c
- c
Remember to go back to The Navigator box on the chapter opening page and check off your completed work.