Accounting: Tools for Business Decision Making PDF

Accounting: Tools for Business Decision Making Eighth Edition Kimmel Weygandt Mitchell Chapter 2 A Further Look at Financial Statements Prepared by...

Accounting: Tools for Business Decision Making Eighth Edition Kimmel Weygandt Mitchell Chapter 2 A Further Look at Financial Statements Prepared by Diane This slide deck contains animations. Please Tanner disable animations if they cause issues with your device. University of North Florida Copyright ©2022 John Wiley & Sons, Inc. Chapter Outline Learning Objectives LO 1 Identify the sections of a classified balance sheet. LO 2 Use ratios to evaluate a company’s profitability, liquidity, and solvency. LO 3 Discuss financial reporting concepts. Learning Objective 1 Identify the Sections of a Classified Balance Sheet LO 1 The Classified Balance Sheet Presents a snapshot of a company’s financial position at a point in time Improves users’ understanding Group similar assets and similar liabilities together based on economic characteristics Standard Classifications Assets Liabilities and Stockholders’ Equity Current asset Current liabilities Long-term investments Long-term liabilities Property, plant, and Stockholders’ equity equipment Intangible assets LO 1 Classified Balance Sheet – Assets Section Franklin Corporation Balance Sheet October 31, 2025 Assets Current assets Cash $ 6,600 Debt investments 2,000 Accounts receivable 7,000 Notes receivable 1,000 Inventory 3,000 Supplies 2,100 Prepaid insurance 400 Total current assets $22,100 Long-term investments Stock investments 5,200 Investment in real estate 2,000 7,200 Property, plant, and equipment Land 10,000 Equipment $24,000 Less: Accumulated depreciation—equipment 5,000 19,00029,000 Intangible assets Patents 3,100 Total assets $61,400 LO 1 Current Assets Assets a company expects to convert to cash or use up within one year or the operating cycle, whichever is longer  Operating cycle The average time it takes to purchase inventory, sell it on account, and then collect cash from customers Most often one year Listed in order of liquidity  Order in which they are expected to turn into cash LO 1 Common Types of Current Assets Cash Investments  Such as short-term U.S. government securities Receivables  Such as accounts receivable, notes receivable, and interest receivable Inventories Prepaid expenses  Such as insurance and supplies LO 1 Current Assets Presentation Southwest Airlines Co. Balance Sheet (partial) (in millions) Current assets Cash and cash equivalents $1,68 0 Short-term investments 1,625 Accounts receivable 546 Inventories 337 Prepaid expenses and other current assets 310 Total current assets $4,49 8 LO 1 Long-Term Investments Can be realized in cash, but the conversion is not expected within one year Often referred to as investments Consist of  Investments in stocks and bonds of other corporations that are held for more than one year  Long-term assets such as land or buildings that a company is not currently using in its operating activities  Long-term notes receivable LO 1 Long-Term Investments Presentation Alphabet Inc. Balance Sheet (partial) (in millions) Long-term investments Non-marketable investments $5,18 3 LO 1 Property, Plant, and Equipment Are assets with relatively long useful lives that are currently used in operations Sometimes called fixed assets or plant assets Includes  Land  Buildings  Equipment  Delivery vehicles  Furniture LO 1 Reporting Property, Plant, and Equipment Reported on the balance sheet at book value  Cost less accumulated depreciation Depreciation  Systematic allocation of cost to expense over a number of years Accumulated depreciation  Total amount of depreciation that the company has expensed thus far in the asset’s life LO 1 Property, Plant, and Equipment Presentation Cooper Tire & Rubber Company Balance Sheet (partial) (in thousands) Property, plant, and equipment Blank Land and land improvements $ 47,767 Buildings 282,960 Machinery and equipment 1,742,44 9 Molds, cores, and rings 224,662 Less: Accumulated depreciation 1,433,66 1 Blank $ 864,227 LO 1 Intangible Assets Assets that do not have physical substance Give the exclusive right of use for a specified time period Includes goodwill, patents, copyrights, and trademarks or trade names Sometimes reported under a broader heading called “Other assets” LO 1 Investor Insight: Best Buy I Heard It Through the Grapevine To show how investor bulletin boards work, suppose that you had $10,000 to invest. You were considering Best Buy, the largest seller of electronics equipment in the United States. You scanned the Internet investor bulletin boards and found messages posted by two different investors. Here are excerpts from actual postings: TMPVenus said “Where are the prospects for positive movement for this company? Poor margins, poor management, astronomical P/E!” Broachman said “I believe that this is a LONG TERM winner, and presently at a good price.” One says sell, and one says buy. Which posting should you believe? If at that time 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 five-year period of time. LO 1 Intangible Assets Presentation The Walt Disney Company Balance Sheet (partial) (in millions) Intangible assets and goodwill blank Character/franchise intangibles and $ 5,829 copyrights Other amortizable intangible assets 893 Accumulated amortization (1,635) Net amortizable intangible assets 5,087 FCC licenses 624 Trademarks 1,218 Other indefinite lived intangible assets 20 blank 6,949 Goodwill 27,810 blank $34,759 LO 1 Knowledge Check: Classifying Assets Classify each of the following into the correct balance sheet classification as either current assets; intangible assets; property, plant, and equipment; or long-term investments. Equipment Property, plant, and equipment Long-term notes Long-term receivable investments Property, plant, and Accumulated depreciation equipment Current assets Inventory Intangible assets Patents Current assets Cash Current Prepaid rent assets LO 1 Classified Balance Sheet – Liabilities and Stockholders’ BalanceEquity Franklin Corporation Sheet October 31, 2022 Section Liabilities and Stockholders’ Equity Current liabilities Notes payable $ 11,000 Accounts payable 2,100 Unearned sales revenue 900 Salaries and wages payable 1,600 Interest payable 450 Total current liabilities $16,050 Long-term liabilities Mortgage payable 10,000 Notes payable 1,300 Total long-term liabilities 11,300 Total liabilities 27,350 Stockholders’ equity Common stock 14,000 Retained earnings 20,050 Total stockholders’ equity 34,050 Total liabilities and stockholders’ equity $61,400 LO 1 Current Liabilities Obligations the company is to pay within the next year or operating cycle, whichever is longer Common examples  Accounts payable, notes payable, salaries and wages payable, interest payable, and income taxes payable  Current maturities of long-term obligations Payments to be made within a year of the balance sheet date on long-term obligations LO 1 Current Liabilities Presentation Alphabet Inc. Balance Sheet (partial) (in millions) Current liabilities Accounts payable $ 1,931 Short-term debt 3,225 Accrued compensation and benefits 3,539 Accrued expenses and other current 10,313 liabilities Income taxes payable, net 302 Total current liabilities $19,31 0 LO 1 Long-Term Liabilities Obligations a company expects to pay after one year Often called long-term debt Often reported as a single amount with the details in the notes to the financial statements Includes long-term notes payable, bonds payable, mortgages payable, lease liabilities, and pension liabilities LO 1 Long-Term Liabilities Presentation Nike, Inc. Balance Sheet (partial) (in millions) Long-term liabilities Bonds payable $5,474 Deferred income taxes and other 1,907 Total long-term liabilities $7,381 LO 1 Stockholders’ Equity Two parts o Common stock Investments of assets into the business by the stockholders o Retained earnings Income retained for use in the business LO 1 Knowledge Check: Classifying Balance Sheet Items Identify the classification of each account name with the following balance sheet classifications. Assets (A) Long-term liabilities (LTL) Current liabilities (CL) Stockholders’ equity (SE) Account names Salaries and wages payable CL Common stock SE Unearned service revenue CL Retained earnings SE Mortgage payable (due in 3 LTL years) A Accumulated depreciation— LO 1 vehicles Test Your Vocabulary: Flashcards and Crossword Puzzles Have some fun! Try out the vocabulary Flashcards and Crossword Puzzles available in your Wiley Course Resources. LO 3 Learning Objective 2 Use Ratios to Evaluate a Company's Profitability, Liquidity, and Solvency LO 2 Ratio Analysis Expresses the mathematical relationship LO 2 among selected items of financial statement data Best Buy’s earnings 2020 2019 per share $5.90 $5.33 LO 2 Financial Ratio Classifications LO 2 Ratio Comparisons 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 LO 2 Using the Income Statement Reveals how successful a company is at generating a profit from selling products or providing services Reports the annual amount earned as revenue during the period and the costs incurred as expenses during the period Evaluated with profitability ratios LO 2 Income Statement Best Buy Co., Inc. Income Statements For the Year Ended February 1, 2020, and the Year Ended February 2, 2019 (in millions) blank 2020 2019 Revenues Net sales and other revenues $43,68 $42,94 6 0 Expenses Cost of good sold 33,590 32,918 Selling, general, and administrative expenses and other 8,103 8,134 Income tax expense 452 424 Total expenses 42,145 41,476 Net income (loss) $ $ 1,541 1,464LO 2 Earnings per Share (EPS) Key profitability ratio Measures the net income earned on each share of common stock Indicates the earnings available to common stockholders  Omits dividends paid to preferred stockholders Used to compare earnings per share of a single company over time Useful perspective for stockholders in determining the investment return who usually think in terms of the number of shares they own LO 2  Computing Earnings Per Share Data for Best Buy in 2020 and 2019 (in millions) (in millions) 2020 2019 Net income $ 1,541 $1,464 Preferred dividends -0- -0- Shares outstanding at beginning of 266 283 year Shares outstanding at end of year Earnings per share calculation for Best 256 266 Buy LO 2 Knowledge Check: EPS The following information is available for Sam Inc. Blank 2025 2024 Net income $80,000 $68,000 Preferred dividends 8,000 5,000 Shares outstanding at beginning of 70,000 50,000 year Shares outstanding at end of year 90,000 70,000 Calculate 2025EPS earnings per $80,000 $8,000 =$0.90 Even though net share for each 70,000+90,000 ÷2 income increased, year. EPS decreased by 2024 EPS $0.15 per share $68,000 $5,000 =$1.05 due to more 50,000+70,000 ÷2 shares outstanding. LO 2 Using a Classified Balance Sheet Assets Section Best Buy Co., Inc. Balance Sheets (in millions) Assets February 1, February 2, 2020 2019 Current assets Cash and cash equivalents $ 2,229 $ 1,980 Receivables 1,149 1,015 Merchandise inventories 5,174 5,409 Other current assets 305 466 Total current assets 8,857 8,870 Property and equipment 9,228 9,200 Less: Accumulated depreciation 6,900 6,690 Net property and equipment 2,328 2,510 Other assets 4,406 1,521 Total assets $15,591 $12,901 LO 2 Using a Classified Balance Sheet Liabilities and Stockholders’ Equity Section Best Buy Co., Inc. Balance Sheets (in millions) Liabilities and Stockholders’ Equity February 1, February 2, 2020 2019 Current liabilities Accounts payable $ 5,288 $ 4,257 Unredeemed gift card liabilities 281 290 Accrued compensation payable 410 482 Other current liabilities 2,081 1,484 Total current liabilities 8,060 7,513 Long-term liabilities Long-term debt 1,257 1,332 Other long-term liabilities 2.795 750 Total long-term liabilities 4,052 2,082 Total liabilities 12,112 9,595 Stockholders’ equity Common stock 26 27 Retained earnings and other 3,453 3,279 Total stockholders’ equity 3,479 3,306 Total liabilities and stockholders’ equity $15,591 $12,901 LO 2 Liquidity Indicates the ability to pay obligations expected to become due within the next year or operating cycle Based on the relationship between current assets and current liabilities Two key measures o Working capital o Current ratio LO 2 Accounting Across the Organization: REL Consultancy Group 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. More recently, a different study found that companies reduced the number of days it took to convert working capital into cash received from customers from 37.1 days down to 35.7 days. Sources: Maxwell Murphy, “The Big Number,” Wall Street Journal (November 9, 2011); and Tatyana Shumsky and Nina Trentmann, “Finance Chiefs Look to Free Up Working Capital Ahead of Rate Increases,” Wall Street Journal (August 21, 2017). LO 2 Working Capital Working Capital = Current Assets – Current Liabilities When current assets exceed current liabilities  Working capital is positive  A greater likelihood that the company will pay its liabilities When current liabilities exceed current assets  Working capital is negative  Ability to pay short-term creditors may be impacted  Company may be forced into bankruptcy LO 2 Current Ratio Measures the short-term ability to pay maturing obligations and meet unexpected needs for cash More dependable indicator of liquidity than working capital Does not take into account the composition of the current assets, like what portion is tied up in slow-moving inventory Important because a dollar of cash is more readily available to pay the bills LO 2 Computing Liquidity Ratios Data from Best Buy’s balance sheets (in millions) Feb. 1, 2020 Feb. 2, 2019 Current assets $8,857 $8,870 Current liabilities 8,060 7,513 2020 Working capital = Current assets − Current liabilities = $8,857 million − $8,060 million 2020 Current ratio = = $797 Currentmillion assets ÷ Current liabilities In 2020, for every dollar of current liabilities, Best Buy has $1.10 of current assets. Liquidity decreased in 2020. LO 2 Knowledge Check: Current Ratio The following information is available for Sam Inc. Blank 2022 2021 Current assets $102,000 $103,200 Total assets 560,000 500,000 Current liabilities 50,000 48,000 Total liabilities 245,000 227,500 2022Current ratio Calculate $102,000 The company’s the =2.04 to 1 liquidity $50,000 current declined from ratio for 2021Current ratio 2.15:1 to each year. 2.04:1. $103,200 =2.15 to 1 $48,000 LO 2 Solvency Measures the ability of the company to survive over a long period of time Indicates a company’s ability to pay interest as it comes due and to repay the balance of a debt due at its maturity Key ratio  Debt to assets ratio LO 2 Debt to Assets Ratio A measure of solvency Measures the percentage of total financing provided by creditors rather than stockholders Ignores whether the company is performing well or not Higher ratios imply greater risk that the company may be unable to pay its debts as they come due Companies with relatively stable earnings generally can support higher debt to assets ratios than can companies with widely fluctuating earnings LO 2 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: Debt to Assets Ratio Google 23% Nike 41 Microsoft 48 ExxonMobil 48 Tesla 76 LO 2 Calculating the Debt to Assets Ratio Data from Best Buy’s balance sheets (in millions) Feb. 1, 2020 Feb. 2, 2019 Total assets $15,591 $12,901 Total liabilities 12,112 9,595 Debt to assets ratio = Total liabilities ÷ Total assets In 2020, every dollar of Best Buy’s assets was financed by 78 cents of debt. Solvency decreased from 2019 to 2020. LO 2 Knowledge Check: Debt to Assets Ratio The following information is available for Sam BlankInc. 2022 2021 Current assets $102,000 $103,200 Total assets 560,000 500,000 Current liabilities 50,000 48,000 Total liabilities 245,000 227,500 2022Debt to assetsratio The company’s Calculate solvency the debt to $245,000 =43.75% improved slightly, assets ratio $560,000 as seen in the for each decline in the year. 2021Debt to assetsratio debt to assets $227,500 ratio from 45.5% =45.50% to 43.75%. $500,000 LO 2 Learning Objective 3 Discuss Financial Reporting Concepts LO 3 The Standard-Setting Environment Generally Accepted Accounting Principles (GAAP) Set of rules and practices, having substantial authoritative support Used by companies to determine  What type of financial information to disclose?  What format to use?  How they should measure assets, liabilities, revenues, and expenses? LO 3 Standard-Setting Bodies Securities and Exchange Commission (SEC)  Oversees U.S. financial markets and accounting standard-setting bodies Financial Accounting Standards Board (FASB)  Primary accounting standard-setting body in the U.S. International Accounting Standards Board (IASB)  Creates international accounting standards (called IFRS)  Used by over 115 countries Public Company Accounting Oversight Board (PCAOB)  Determines U.S. auditing standards and reviews the performance of auditing firms LO 3 World View of the Standard Setting Environment LO 3 Knowledge Check: Standard-Setting Environment 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 Supreme Court. c. the guidelines used to prepare tax returns. d. fundamental truths that can be derived LO 3 Knowledge Check: Standard- Setting Environment Answer Generally accepted accounting principles are a. Answer: a set of standards and rules that are recognized as a general guide for financial reporting. b. usually established by the Supreme Court. c. the guidelines used to prepare tax returns. d. fundamental truths that can be derived LO 3 International Insight The Korean Discount If you think that accounting standards don’t matter, consider past 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 adopted 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, and Japan, have either adopted international standards or created standards that are based on the international standards. Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007) LO 3 Qualities of Useful Information: Conceptual Framework Serves as the basis for future accounting standards Used by the FASB and IASB States the primary objective of financial reporting  To provide financial information that is useful to investors and creditors for making decisions about providing capital Indicates two primary qualities of useful information  Relevance  Faithful representation LO 3 Relevance Makes a difference in a business decision Must have predictive value  Helps provide accurate expectations about the future Must have confirmatory value  Confirms or corrects prior expectations Materiality  Company-specific aspect of relevance  Exists if omitting information or misstating it could influence the decision of a financial statement user LO 3 Faithful Representation Information accurately depicts what really existed or happened Must be  Complete Nothing important has been omitted  Neutral Not biased toward one position or another  Free from material error LO 3 Enhancing Qualities: Comparability and Consistency Comparability Consistency Results when different Means that a company companies use the uses the same same accounting accounting principles principles and methods from year to year LO 3 Enhancing Qualities: Verifiable, Timely, and Understandability Verifiable Understandability Information that Information that is presented in a clear and concise fashion independent observers, so that reasonably informed using the same methods, users of that information can can obtain similar results interpret it and comprehend its meaning Timely Information must be available to decision-makers before it loses its capacity to influence decisions LO 3 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 on December 31. Why do companies choose particular year-ends that they do? For example, why doesn’t every company use December 31 as its 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; The Walt Disney Company, 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 January. LO 3 Assumptions in Financial Reporting: Monetary Unit andEconomic EconomicEntity Monetary Unit Assumption Entity Assumption Requires that only those States that every things that can be economic entity can be expressed in money are separately identified and included in the accounting accounted for Must not blur company records transactions with personal Relies on a relatively stable transactions monetary unit LO 3 Assumptions in Financial Reporting: Periodicity and Going Concern Going Concern Periodicity Assumption Assumption States that the States that the life of a business will remain in operation for the business can be divided foreseeable future into artificial time periods and that useful reports covering those periods can be prepared for the business LO 3 Principles in Financial Reporting: Measurement Principles GAAP generally uses one of two measurement principles  Historical cost principle  Fair value principle Selection of which principle to follow relates to trade-offs between relevance and faithful representation LO 3 Historical Cost Principle Companies record assets at the cost to acquire the asset at the time the asset is purchased  Cost remains in the accounting records over the time the asset is held FASB indicates that most assets must follow the historical cost principle because market values may not be representationally faithful LO 3 Fair Value Principle Assets and liabilities should be reported at fair value  Price that would be received if an asset was sold or the amount that would be required to be paid to settle a liability Used only in situations where assets are actively traded Two qualities used in choosing between cost and fair value—relevance and faithful representation LO 3 Full Disclosure Principle Disclose all circumstances and events that would make a difference to financial statement users Most often reported directly in one of the four types of financial statements  An important item that cannot reasonably be reported in the statements must be discussed in notes that accompany the statements LO 3 Cost Constraint Consider cost in deciding whether to provide a certain type of information Weigh information cost against the benefit that financial statement users will gain from having the information available LO 3 Summary of Conceptual Framework LO 3 Knowledge Check: Concepts and Principles - Part 1 with the appropriate concept or principle. Match each item 1. Ability to easily evaluate one Comparability company’s results relative to another’s 2. Belief that a company will continue to operate for the foreseeable future Going concern 3. The judgment concerning whether an item is large Materiality enough to matter to decision-makers 4. The reporting of all information that would make a difference to Full disclosure financial statement users LO 3 Knowledge Check: Concepts and Principles - Part Match each2 principle. item with the appropriate concept or 5. The practice of preparing Periodicity financial statements at regular intervals 6. The quality of information that indicates the information Relevance makes a difference in a decision 7. A belief that items should be Historical reported on the balance sheet cost at the price that was paid to acquire the item 8. A company’s use of the same accounting principles and Consistency methods from year to year LO 3 Knowledge Check: Concepts and Principles - Part Match each principle. 3item with the appropriate concept or 9. The requirement that a company Economic entity must keep separate accounting records from personal accounting records 10. The desire to minimize errors Faithful and bias in financial statements representation 11. Reporting only those things Monetary unit that can be measured in dollars LO 3 Copyright Copyright © 2022 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. 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