CHAPTER Foundations of Financial Reporting and the Classified Balance Sheet Principles of Accounting 12e Needles Powers Crosson © human/iStockphoto LEARNING OBJECTIVES LO1: Describe the objective of financial reporting, and identify the conceptual framework underlying accounting information LO2: Identify and define the basic components of financial reporting, and prepare a classified balance sheet LO3: Use classified financial statements to evaluate liquidity and profitability ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part SECTION 1: CONCEPTS (slide of 3) Re le vanc e : information has a direct bearing on a decision – Pre dic tive value : information helps capital providers make decisions about future actions – Co nfirmative value : information confirms or changes previous evaluations – Mate riality: the omission or misstatement of information could influence the user’s economic decisions taken on the basis of the financial statements Faithful re pre s e ntatio n: information is complete, neutral, and free from material error – Co mple te ne s s : all information necessary for a reliable decision is provided – Ne utrality: information is free from bias intended to achieve a certain result or bring about a particular behavior – Fre e fro m mate rial e rro r: information meets a minimum level of accuracy so it does not distort what is being reported ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part SECTION 1: CONCEPTS (slide of 3) Enhanc ing qualitative c harac te ris tic s – Co mparability: the quality that enables users to identify similarities and differences between two sets of financial data – Ve rifiability: the quality that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation – Time line s s : the quality that enables users to receive information in time to influence their decisions – Unde rs tandability: the quality that enables users to comprehend the meaning of information – Co s t c o ns traint (c o s t-be ne fit): the benefits to be gained from providing accounting information should be greater than the costs of providing it ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part SECTION 1: CONCEPTS (slide of 3) Ac c o unting c o nve ntio ns : constraints used in preparing financial statements – Co ns is te nc y: once a company has adopted an accounting procedure, it must use it from one period to the next unless a note to the financial statements informs users of a change – Full dis c lo s ure (trans pare ncy): financial statements must present all the information relevant to users’ understanding of the statements – Co ns e rvatis m: when faced with choosing between two equally acceptable procedures or estimates, accountants should choose the one that is least likely to overstate assets and income ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Objective of Financial Reporting To be useful for decision making, financial reporting must enable the user to – Assess cash flow prospects – Assess management’s stewardship Financial reporting includes the financial statements (balance sheet, income statement, statement of owner’s equity, and statement of cash flows) that are prepared periodically – Management’s underlying assumptions and methods and estimates used in the financial statements are also important components of financial reporting ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Qualitative Characteristics of Accounting Information To facilitate interpretation of accounting information, the FASB has established standards, or qualitative c harac te ris tic s , by which to judge the information The most fundamental of these characteristics are: – Relevance – Faithful representation ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Relevance (slide of 2) Re le vanc e means that the information has a direct bearing on a decision In other words, if the information were not available, a different decision would be made – To be relevant, information must have one or both of the following: Predictive value—Information has pre dic tive value if it helps capital providers make decisions about future actions Confirmative value—Information has c o nfirmative value if it confirms or changes previous evaluations ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Relevance (slide of 2) Relevant information is also subject to m ate riality – Information is mate rial if its omission or misstatement could influence the user’s economic decisions taken on the basis of the specific entity’s financial statements – Mate riality is related to both the nature of an item and its size or misstatement The materiality of an item normally is determined by relating its dollar value to an element of the financial statements, such as net income or total assets As a rule, when an item is worth percent or more of net income, accountants treat it as material However, many small errors can add up to a material amount ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Faithful Representation Faithful re pre s e ntatio n means that the financial information is complete, neutral, and free from material errors – Co mple te info rmatio n provides all information necessary for a reliable decision – Ne utral info rmatio n is free from bias intended to achieve a certain result or to bring about a particular behavior – To be fre e fro m mate rial e rro r means information meets a minimum level of accuracy so it does not distort what is being reported ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Owner’s Equity The terms owne r’s e quity, proprie tors hip, owne r’s capital, and ne t worth are all used to refer to the owner’s interest, or equity, in a company – The first three terms are preferred to ne t worth because many assets are recorded at their original cost rather than at their current value The equity section of the balance sheet differs depending on whether the business is a sole proprietorship, partnership, or corporation ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Sole Proprietorship The owner’s equity section of a sole proprietorship would be similar to the one shown for Bonali Company: ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Partnership The equity section of a partnership’s balance sheet is called partne rs ’ e quity It is much like that in a sole proprietorship’s balance sheet and might appear as follows: ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Corporation (slide of 2) The equity section of a balance sheet for a corporation is called s to c kho lde rs ’ e quity (or s hare holde rs ’ e quity) It has two parts, contribute d capital and re taine d e arnings The Co ntribute d Capital (or Paid-in Capital) account reflects the amount of assets invested by stockholders It is generally shown on corporate balance sheets by two amounts: – the face, or par, value of issued stock – the amounts paid in, or contributed, in excess of the par value per share ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Corporation (slide of 2) The Re taine d Earning s account is sometimes called Earne d Capital because it represents the stockholders’ claim to the assets that are earned from operations and reinvested in corporate operations Distributions of assets to shareholders, which are called divide nds , reduce the Retained Earnings account just as withdrawals of assets by the owner of a business reduce the Capital account ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Overview of Classified Balance Sheet Accounts Similar accounts on the balance sheet and income statement can be grouped, as shown below ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Using Classified Financial Statements Ratios use the components of classified financial statements to reflect how well a firm has performed in terms of maintaining liquidity and achieving profitability Accounts must be classified correctly before the ratios are computed, or the ratios will be incorrect ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Evaluation of Liquidity Liquidity means having enough money on hand to pay bills when they are due and to take care of unexpected needs for cash Two measures of liquidity are working capital and curre nt ratio Wo rking c apital is the amount by which current assets exceed current liabilities ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Current Ratio The c urre nt ratio is the ratio of current assets to current liabilities To determine whether a current ratio is good or bad, it must be compared with ratios for earlier years and with similar measures for companies in the same industry ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Evaluation of Profitability Pro fitability is the ability to earn a satisfactory income – Profitability competes with liquidity because liquid assets are not the best profit-producing resources – Ratios commonly used to evaluate a company’s ability to earn income include: Profit margin Asset turnover Return on assets Debt to equity ratio Return on equity ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Profit Margin The pro fit marg in shows the percentage of each sales dollar that results in net income – It is an indication of how well a company is controlling its costs: the lower its costs, the higher its profit margin – To determine whether this is a satisfactory profit, it must be compared with the profit margin of other companies in the same industry ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Asset Turnover The as s e t turno ve r ratio measures how efficiently assets are used to produce sales – A company with a high asset turnover uses its assets more productively than one with a low asset turnover – Asset turnover is computed by dividing revenues by average total assets Average total assets are the sum of assets at the beginning and the end of the period, divided by ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Return on Assets The re turn o n as s e ts ratio relates net income to average total assets – This ratio combines the firm’s income-generating strength (profit margin) and its revenuegenerating effectiveness (asset turnover) ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Debt to Equity Ratio The de bt to e quity ratio shows the proportion of a company’s assets financed by creditors and the proportion financed by the owner – This ratio is relevant to profitability, as well as liquidity, because the more debt a company has, the more profit it must earn to ensure payment of interest to creditors and a return on the owner’s investment ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Return on Equity Re turn o n e quity is the ratio of net income to average owner’s equity – Return on equity will always be greater than return on assets because total equity will always be less than total assets ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part ... Describe the objective of financial reporting, and identify the conceptual framework underlying accounting information LO2: Identify and define the basic components of financial reporting, and... Characteristics of Accounting Information To facilitate interpretation of accounting information, the FASB has established standards, or qualitative c harac te ris tic s , by which to judge... accessible website, in whole or in part Ethical Financial Reporting Under the Sarbanes-Oxley Act, chief executive officers and chief financial officers of all publicly traded companies must certify