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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.
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Accounting Conventions for Preparing
Financial Statements
OBJECTIVE 2: Define and describe the
conventions of consistency, full disclosure,
materiality, conservatism, and cost-benefit.
Accounting Conventions for Preparing
Financial Statements
• Consistency
– Once a company has adopted an accounting
procedure, it must use it from one period to the
next unless otherwise noted.
Accounting Conventions for Preparing
Financial Statements
• Full disclosure (transparency)
– Financial statements must present all
information relevant to users’ understanding of
the statements
– Explanatory notes disclosing changes in
account procedures, or significant events
occurring after balance sheet dates
Accounting Conventions for Preparing
Financial Statements
• Materiality
– Relative importance of an item or event
– Materiality determined by relating its dollar
value to an element of the financial statements
Accounting Conventions for Preparing
Financial Statements
• Conservatism
– When a choice between two equally acceptable
procedures, chose the one least like to overstate assets
or income
– Useful, but can be abused, so accountants should only
depend on it when uncertain about which procedure or
estimate to use.
• Cost-benefit
– The benefit gained from providing information should
be greater than the cost of providing it.
– Costs and benefits are both immediate and deferred.
Accounting Conventions for Preparing
Financial Statements
• Cost-benefit
– The benefit gained from providing information
should be greater than the cost of providing it.
– Costs and benefits are both immediate and
deferred.
©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)
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Forms of the Income Statement
OBJECTIVE 4: Describe the features of
multistep and single-step classified income
statements.
Figure 3: The Components of Multistep Income
Statements for Service and Merchandising or
Manufacturing Companies
Exhibit 3: Multistep Income Statement for
Cruz Company
Exhibit 4: Multistep Income Statement for
Dell Computer Corporation
Exhibit 5: Single-Step Income Statement
for Cruz Company
Forms of the Income Statement
• The multistep income statement arrives at net
income through a series of steps, or subtotals,
including gross margin and income from
operations.
–
–
–
–
–
–
–
–
Net sales
Cost of goods sold
Gross margin
Operating expenses
Income from operations
Other revenues and expenses
Income taxes
Net income
Forms of the Income Statement
• The single-step income statement arrives at
net income in a single step. The single-step
form is a simple deduction of all costs and
expenses from all revenues.
©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.