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5 Financial Reporting and Analysis Foundations of Financial Reporting OBJECTIVE 1: Describe the objective of financial reporting and identify the qualitative characteristics, conventions, and ethical considerations of accounting information. Figure 1: Factors Affecting Financial Reporting Foundations of Financial Reporting • Objective of financial reporting – Assess cash flow prospects • Ability to pay dividends, interest and returns to capital – Assess stewardship • Provide information about business resources, claims to those resources, and changes in them – General-purpose external financial statements consist of the balance sheet, income statement, statement of retained earnings, and statement of cash flows. Foundations of Financial Reporting • Qualitative characteristics facilitates a user’s interpretations of accounting information – Information should be relevant, meaning it has direct bearing on a decision • Predictive value • Confirmative value • Both Foundations of Financial Reporting • Qualitative characteristics facilitates a user’s interpretations of accounting information (cont.) – The information should be a faithful representation of the entity. • Complete, neutral, and free from material error – Information does not have to be absolutely accurate but major uncertainties should be disclosed. Foundations of Financial Reporting • Qualitative characteristics facilitates a user’s interpretations of accounting information (cont.) – Four qualitative characteristics complement the quality of information • • • • Comparability Verifiability Timeliness Understandability Foundations of Financial Reporting • Accounting conventions are constraints on accounting and the preparation of financial statements to better enable the user to understand the information being presented. • Under the Sarbanes-Oxley Act, the CEO and CFO of public companies must certify the financial statements and the system of internal control. ©2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part. Accounting Conventions for Preparing Financial Statements OBJECTIVE 2: Define and describe the conventions of consistency, full disclosure, materiality, conservatism, and cost-benefit. Accounting Conventions for Preparing Financial Statements • Consistency – Once a company has adopted an accounting procedure, it must use it from one period to the next unless otherwise noted. Accounting Conventions for Preparing Financial Statements • Full disclosure (transparency) – Financial statements must present all information relevant to users’ understanding of the statements – Explanatory notes disclosing changes in account procedures, or significant events occurring after balance sheet dates Accounting Conventions for Preparing Financial Statements • Materiality – Relative importance of an item or event – Materiality determined by relating its dollar value to an element of the financial statements Accounting Conventions for Preparing Financial Statements • Conservatism – When a choice between two equally acceptable procedures, chose the one least like to overstate assets or income – Useful, but can be abused, so accountants should only depend on it when uncertain about which procedure or estimate to use. • Cost-benefit – The benefit gained from providing information should be greater than the cost of providing it. – Costs and benefits are both immediate and deferred. Accounting Conventions for Preparing Financial Statements • Cost-benefit – The benefit gained from providing information should be greater than the cost of providing it. – Costs and benefits are both immediate and deferred. ©2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part. Classified Balance Sheet OBJECTIVE 3: Identify and describe the basic components of a classified balance sheet. Classified Balance Sheet • Classified financial statements are generalpurpose external financial statements that are divided into subcategories to provide more useful information to the reader. • A classified balance sheet divides assets, liabilities, and owner’s equity into subcategories to facilitate decision-making. Figure 2 Classified Balance Sheet Classified Balance Sheet • There are usually four categories of assets on the classified balance sheet. These categories are listed in declining order of liquidity. (Some companies use another category called other assets to group all assets other than current assets and property, plant, and equipment.) – Current assets • The normal operating cycle, a concept used in the classification of assets, is the time a company needs to go from spending cash to receiving cash. – Investments – Property, plant, and equipment – Intangible assets Classified Balance Sheet • Liabilities on the classified balance sheet are usually divided into two categories. – Current liabilities – Long-term liabilities • In a sole proprietorship the owner’s equity section shows the capital in the owner’s name at an amount equal to the net assets of the company. Exhibit 1 Classified Balance Sheet for Cruz Company Exhibit 1 Classified Balance Sheet for Cruz Company (cont.) Exhibit 2 Classified Balance Sheet for Dell Corporation Exhibit 2 (Continued) ©2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part. Forms of the Income Statement OBJECTIVE 4: Describe the features of multistep and single-step classified income statements. Figure 3: The Components of Multistep Income Statements for Service and Merchandising or Manufacturing Companies Exhibit 3: Multistep Income Statement for Cruz Company Exhibit 4: Multistep Income Statement for Dell Computer Corporation Exhibit 5: Single-Step Income Statement for Cruz Company Forms of the Income Statement • The multistep income statement arrives at net income through a series of steps, or subtotals, including gross margin and income from operations. – – – – – – – – Net sales Cost of goods sold Gross margin Operating expenses Income from operations Other revenues and expenses Income taxes Net income Forms of the Income Statement • The single-step income statement arrives at net income in a single step. The single-step form is a simple deduction of all costs and expenses from all revenues. ©2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part. Using Classified Financial Statements OBJECTIVE 5: Use classified financial statements to evaluate liquidity and profitability. Figure 4: Average Current Ratio for Selected Industries Figure 5: Average Profit Margin for Selected Industries Figure 6: Average Asset Turnover for Selected Industries Figure 7: Average Return on Assets for Selected Industries Figure 8: Average Debt to Equity Ratio for Selected Industries Figure 9: Average Return on Equity for Selected Industries Using Classified Financial Statements • Liquidity measures a company’s ability to pay its bills when they fall due. – Working capital is current assets minus current liabilities. – The current ratio is current assets divided by current liabilities. Using Classified Financial Statements • Profitability may be measured several ways. – Profit margin—net income divided by net sales – Asset turnover—net sales divided by average total assets – Return on assets—net income divided by average total assets – Debt to equity ratio—total liabilities divided by owner’s equity – Return on equity—net income divided by average owner’s equity ©2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part. Exhibit S-1: CVS’s Income Statements Exhibit S-2: CVS’s Balance Sheets Exhibit S-2: CVS’s Balance Sheets (cont’d) Exhibit S-3: CVS’s Statements of Cash Flows Exhibit S-3: CVS’s Statements of Cash Flows Exhibit S-4: CVS’s Statements of Shareholders’ Equity Exhibit S-4: CVS’s Statements of Shareholders’ Equity Exhibit S-4: CVS’s Statements of Shareholders’ Equity Figure S-1: Auditor’s Report for CVS Caremark Corporation Supplement to Chapter 5: How to Read an Annual Report • Components of an Annual Reports – – – – Letter to the Stockholders Financial Highlights Description of the Company Management’s Discussion and Analysis Supplement to Chapter 5: How to Read an Annual Report • Financial Statements – Formal financial statements appear in an annual report, usually in comparative form. – Consolidated financial statements are combined statements of affiliated companies. – A statement of stockholders’ equity often replaces the owner’s equity statement. Supplement to Chapter 5: How to Read an Annual Report • Notes to the Financial Statements – A summary of significant accounting policies should accompany the financial statements. – Notes to the financial statements interpret portions of the financial statements. – Corporations frequently issue interim financial statements that cover less than a year. Supplement to Chapter 5: How to Read an Annual Report • An annual report usually includes a report of management’s responsibilities as well as management’s discussion and analysis of operations. Supplement to Chapter 5: How to Read an Annual Report • The independent auditors’ report accompanies the financial statements. – The first paragraph identifies the financial statements and responsibilities. – The scope section describes the extent of the examination. – The opinion section expresses the fairness of presentation of the financial statements. – The fourth paragraph identifies any new accounting standards adopted by the company – The fifth paragraph says the company’s internal controls are effective.