10e_resmat_ch5.doc

CHAPTER 5 Financial Reporting and Analysis Resource Materials and Outlines OBJECTIVE 1: Describe the objectives and qualitative characteristics of financial reporting and the ethical responsibilities that financial reporting involves. Summary Statement Financial reporting should fulfill three objectives. It should (1) furnish information useful in making investment and credit decisions; (2) provide information useful in assessing cash flow prospects; and (3) provide information about business resources, claims to those resources, and changes in them. General-purpose external financial statements, which are the principal means of communicating financial information to interested parties, consist of the balance sheet, income statement, statement of owner’s equity, and statement of cash flows. Accounting attempts to provide decision makers with information that displays qualitative characteristics, or standards, of understandability and usefulness, by which to judge the accounting information. Understandability is the qualitative characteristic that enables users to perceive its meaning, often by utilizing accounting conventions, or rules of thumb, used in preparing financial statements. Usefulness is the qualitative characteristic that is relevant and reliable. . Relevance means that the information has a direct bearing on a decision. To be relevant, information must provide feedback, help predict future conditions, and be timely. . Reliability means that the accounting information reflects accurately what it is meant to represent. To be reliable, information must be verifiable, neutral, and faithful. Under the Sarbanes-Oxley Act, the CEO and CFO of public companies must certify the financial statements and the system of internal control. New Concepts and Terminology qualitative characteristics; understandability; accounting conventions; usefulness; relevance; reliability Related Text Illustration Figure 1: Factors Affecting Financial Reporting Lecture Outline . Financial reporting should fulfill three objectives. . Furnish useful information for making investment and credit decisions . Provide information useful in assessing cash flow prospects . 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. . Accounting information should possess the qualitative characteristics of understandability and usefulness. . Understandability is the characteristic that enables users to perceive its meaning, often by utilizing accounting conventions, or rules of thumb, used in the preparation of financial statements. . Usefulness is the characteristic of information that is relevant and reliable. . Relevance—Accounting information should provide meaningful feedback, help predict future conditions, and be timely. . Reliability—Accounting information should be verifiable, neutral, and a faithful representation. . Under the Sarbanes-Oxley Act, the CEO and CFO of public companies must certify the financial statements and the system of internal control. Teaching Strategy In learning the processes required in the accounting cycle, students may lose sight of the ultimate purpose to which each step leads: the presentation of financial statements for various uses. This section is an opportunity to review a list of users of financial information. Now that students have a new understanding of the construction of financial statements, it is helpful to discuss various accounts and their relationship to the whole statement to draw attention to a particular user and use (e.g., a loan officer at a bank may be particularly interested in total liabilities in relation to total assets). Up to this point in the course, students have been trained to expect total accuracy in all accounting transactions. This is their first exposure to the concept of estimation of amounts on financial statements. Discuss this concept. Using depreciation as an example helps students understand what is meant by approximation. Take care to define depreciation, but do not attempt to teach methods at this time. Figure 1 should be used to sort out the definitions of terms. GAAP provide specific applications of usefulness, relevance, and reliability. Students should commit the specific terms to memory. The topic of qualitative characteristics of accounting information lends itself well to an essay question; a reconstruction of Figure 1, with some terminology left blank, is an appropriate test of comprehension. OBJECTIVE 2: Define and describe the conventions of comparability and consistency, materiality, conservatism, full disclosure, and cost-benefit. Summary Statement To help make financial statements more meaningful, accountants depend on the following conventions, or rules of thumb, in recording transactions and preparing financial statements. Comparability means enabling the decision maker to recognize similarities, differences, and trends over different periods in the same company and among different companies. The consistency convention requires that 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 in procedure. But if a company does change a procedure, it must disclose both the dollar effect on the statements and justification for the change. The materiality convention refers to the relative importance of an item or event in a financial statement and its influence on the decisions of the users of financial statements. It states that an item should be disclosed separately or treated specially if knowledge of it would influence the user’s decision. Whether a dollar amount is material or not is a matter of professional judgment, which should be exercised in a fair and accurate manner. The conservatism convention holds that when faced with two equally acceptable accounting procedures, the accountant should choose the one that is least likely to overstate assets and income. Applying the lower-of-cost-or-market rule to inventory valuation is an example of conservatism. The full disclosure convention requires that a company’s financial statements and their accompanying notes present all information relevant to the users’ understanding of the statements. The cost-benefit convention holds that the benefits gained from providing accounting information should be greater than the costs of providing that information. New Concepts and Terminology comparability; consistency; materiality; conservatism; full disclosure; cost-benefit  Related Text Illustrations Focus on Business Practice: Are Yahoo and Google Comparable? Can an Internet Company Be Conservative? Focus on Business Practice: How Much Is Material? It’s Not Only a Matter of Numbers Focus on Business Practice: When Is “Full Disclosure” Too Much? It’s a Matter of Cost and Benefits Lecture Outline . The following conventions help interpret the qualitative characteristics discussed in Learning Objective 1: . Comparability and consistency . Materiality . Conservatism . Full disclosure . Cost-benefit Teaching Strategy Each of the characteristics in this section should be discussed in depth. For the continuing accounting student, these are terms that are used in the literature and should be a guiding force in decision making. Although this section is heavy on theory, it can be conceptually linked to the mechanics of the accounting process with the use of examples. Most accounting students, when first exposed to these terms, do not see the significance of these concepts. It may be wise to force a focus on this material by including these topics in an exam. Short Exercise 2 and Exercises 3 and 4 are appropriate for classroom discussion of this topic. Cases 1 and 2 are excellent problems for conceptual analyses of this topic. Essay questions requiring definition of terms are an appropriate subjective-test approach to this topic; matching terms with the concepts underlying those terms is an appropriate objective-test approach to this topic. OBJECTIVE 3: Identify and describe the basic components of a classified balance sheet. Summary Statement Classified financial statements are general-purpose external financial statements that are divided into subcategories to provide more useful information to the reader. The balance sheets presented thus far categorize accounts as assets, liabilities, and owner’s equity. On a classified balance sheet, assets are usually divided into four categories: (1) current assets; (2) investments; (3) property, plant, and equipment; and (4) intangible assets. These categories are usually listed in the order of their presumed ease of conversion into cash. (Some companies use another category called other assets to group all assets other than current assets and property, plant, and equipment.)  Current assets comprise cash and other assets that a company can reasonably expect to convert to cash, sell, or use up within one year or its normal operating cycle, whichever is longer. The normal operating cycle of a company is the average time it needs to go from spending cash to receiving cash. Cash, short-term investments, accounts receivable, notes receivable, prepaid expenses, supplies, and inventory are current assets. Investments include assets, usually long-term, that are not used in normal business operations and that management does not plan to convert to cash within the next year. Included in this category are securities held for long-term investment, long-term notes receivable, land held for future use, plant and equipment not used in the business, special funds, and a controlling interest in another company. Property, plant, and equipment are tangible long-term assets used in the continuing operation of a business. They represent a place to operate (land and buildings) and the equipment used to produce, sell, and deliver goods or services. They are also called operating assets, fixed assets, tangible assets, long-lived assets, or plant assets. This category includes land, buildings, delivery equipment, machinery, office equipment, and natural resources owned by the company, if they are used in the regular course of business. All except land are subject to depreciation. Intangible assets are long-term assets with no physical substance whose value stems from the rights or privileges they extend to their owners. Examples are patents, copyrights, goodwill, franchises, and trademarks. The liabilities of a classified balance sheet are divided into two categories: current liabilities and long-term liabilities. Current liabilities consist of obligations due to be paid or performed within one year or within the normal operating cycle of the business, whichever is longer. They are paid from current assets or from the incurring of new short-term liabilities. Examples are notes payable, accounts payable, the current portion of long-term debt, salaries and wages payable and customer advances (unearned revenues). Long-term liabilities comprise debts that fall due more than one year in the future or beyond the normal operating cycle, which will be paid from noncurrent assets. Examples are mortgages payable, long-term notes payable, bonds payable, employee pension obligations, and long-term leases. The owner’s equity section of a classified balance sheet can be called owner’s equity, partners’ equity, or stockholders’ equity. The exact name depends on whether the business is a sole proprietorship, a partnership, or a corporation. In a corporation, the stockholders’ equity section consists of contributed capital and retained earnings. Contributed capital (sometimes called paid-in capital) is the amount invested by the stockholders. It is divided further into the par value of the issued stock and the paid-in, or contributed, capital in excess of the par value per share. Retained earnings (sometimes called earned capital) reflect the earnings record of the company since its beginning. Dividends (assets distributed to stockholders) reduce the Retained Earnings account balance, as do net losses. In a sole proprietorship or partnership, the owner’s equity section shows the capital in the owner’s name at an amount equal to the net assets of the company. Each name is followed by the word “Capital” and the dollar amount of investment as of the balance sheet date. New Concepts and Terminology classified financial statements; other assets; current assets; normal operating cycle; investments; property, plant, and equipment; intangible assets; current liabilities; long-term liabilities; contributed capital; retained earnings Related Text Illustrations Figure 2: Classified Balance Sheet Exhibit 1: Classified Balance Sheet for Ling Auto Supply Company Focus on Business Practice: There’s More Than One Way to Balance a Balance Sheet Exhibit 2: Classified Balance Sheet for Dell Computer Corporation Lecture Outline . Classified financial statements are general-purpose 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. . 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 . 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. Teaching Strategy For this section, attention to detail is of the utmost importance. Take the time to review Exhibit 1 and the sections, account titles, and calculations in the balance sheet. At first, students are intimidated by the length and complexity of this statement. Assure them that the basic accounting equation is still represented and that the broad account categories are unchanged, but that detail has been added. Care in defining subcategories is helpful (current assets, investments, and so on). A redefinition of the three basic forms of business is helpful. Point out how the owner’s or stockholders’ equity section for each form is presented. There is particular confusion about the owner’s equity section. It is best to introduce the topic, point out the account titles, indicate that they are “equity” accounts, and define the terms used. Short Exercises 3 and 4 and Exercises 5 and 6 pertain to classification of accounts on the balance sheet. Introduce a real company’s balance sheet (Exhibit 2) and discuss the differences and similarities to the text discussion of a balance sheet. OBJECTIVE 4: Describe the features of multistep and single-step classified income statements. Summary Statement In the income statements presented thus far, expenses have been deducted from revenue in a single step to arrive at net income. In the single-step income statement, the revenues section lists all revenues, including other income, and the costs and expenses section lists all expenses, including other expenses. Many companies, however, use a form of income statement that is more detailed, containing several subtractions and subtotals: Net Sales – Cost of Goods Sold = Gross Margin – Operating Expenses = Income from Operations ± Other Revenues and Expenses = Net Income A multistep income statement goes through a series of steps, or subtotals, to arrive at net income. It is used by a merchandising company, which buys and sells products, and a manufacturing company, which makes and sells products. Four major parts of the merchandising or manufacturing company’s multistep income statement are net sales, cost of goods sold, gross margin, and operating expenses. Net sales, often simply called sales, are the gross proceeds from sales of merchandise (gross sales) less sales returns and allowances and any discounts allowed. Gross sales are the total sales for cash and on credit that occur during an accounting period. Sales returns and allowances are cash refunds, credits on account, and discounts from selling prices made to customers who have received defective products or products that are otherwise unsatisfactory. Cost of goods sold, also called cost of sales, is the amount a merchandiser paid for the merchandise it sold during an accounting period or the cost to a manufacturer of making the products it sold during an accounting period. Gross margin, or gross profit, is the difference between net sales and the cost of goods sold. Operating expenses are expenses other than cost of goods sold that are incurred in running a business. Income from operations, or operating income, is the gross margin minus operating expenses and represents the income from a company’s normal, or main, business. Other revenues and expenses on a classified income statement include revenues and expenses not related to business operations, such as those from dividends and interest on stocks, bonds, and savings accounts. Net income is what remains of the gross margin after operating expenses are deducted, and other revenues and expenses are added or deducted New Concepts and Terminology multistep income statement; merchandising company; manufacturing company; net sales; gross sales; sales returns and allowances; cost of goods sold; gross margin; operating expenses; income from operations; other revenues and expenses; net income; single-step income statement Related Text Illustrations Figure 3: The Components of Multistep Income Statements for Service and Merchandising or Manufacturing Companies Exhibit 3: Multistep Income Statement for Ling Auto Supply Company Exhibit 4: Multistep Income Statement for Dell Computer Corporation Exhibit 5: Single-Step Income Statement for Ling Auto Supply Company Lecture Outline . 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 . Net income . 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. Teaching Strategy To help students understand the merchandising or manufacturing company’s multistep income statement, you may want to reproduce Exhibit 3 and explain it line by line. Figure 3 is helpful in understanding the cost of goods sold computation. Explain the meanings of gross and net. Students may already be familiar with gross pay and net pay. Suggest to students that they prepare flashcards to drill themselves on the various computations included in this objective. Be sure to explain the nature of the expense “cost of goods sold” and to contrast it with selling and administrative expenses. Compare and contrast the income statements in Exhibits 3 and 5. Note which items appear exclusively on the multistep income statement. Ask students which form they prefer. This will lead to a discussion of the advantages and disadvantages of each form. Point out that the form of the income statement does not change the bottom line. Exhibit 4 is a multistep income statement for a real company, Dell Computer Corporation, which students should examine. Short Exercises 5 through 8 and Exercises 7 through 9 pertain to the classification of income statement accounts and the preparation of both forms of income statement. OBJECTIVE 5: Use classified financial statements to evaluate liquidity and profitability. Summary Statement Classified financial statements help the reader evaluate liquidity and profitability. Liquidity measures a company’s ability to pay its bills when they are due and to provide for unanticipated needs for cash. Two measures of liquidity are working capital and the current ratio. Working capital equals current assets minus current liabilities. It equals the current asset amount that would remain if all the current debts were paid or obligations were performed. The current ratio equals current assets divided by current liabilities. A current ratio of 1, for example, shows that current assets are barely enough to settle current liabilities; a current ratio of 2 is considered more satisfactory. Profitability is the ability to earn a satisfactory income. To draw conclusions, measures of profitability must be compared with past performance and industry averages. Five measures of profitability are the profit margin, asset turnover, return on assets, debt to equity ratio, and return on equity. The profit margin shows the percentage of each sales dollar that results in net income. It equals net income divided by net sales. A 12.5 percent profit margin, for example, means that 12.5 cents have been earned on each dollar of sales. Asset turnover shows how efficiently assets are used to produce sales. It equals net sales divided by average total assets. Return on assets shows how efficiently a company uses its assets to produce income. It equals net income divided by average total assets. The debt to equity ratio shows the proportion of a business’s assets that is financed by creditors and the proportion financed by stockholders. It equals total liabilities divided by stockholders’ equity. A debt to equity ratio of 1.0 indicates equal financing by creditors and stockholders. Return on equity (return on owner’s investment) relates the amount earned by a business to the stockholders’ investment in the business. It equals net income divided by average stockholders’ equity. New Concepts and Terminology working capital; current ratio; profit margin; asset turnover; return on assets; debt to equity ratio; return on equity Related Text Illustrations Figure 4: Average Current Ratio for Selected Industries Focus on Business Practice: Who Is Right: The Credit-Worthiness Analyst or the Profitability Analyst? Figure 5: Average Profit Margin for Selected Industries Figure 6: 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 Focus on Business Practice: To What Level of Profitability Should a Company Aspire? Lecture Outline . 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. . 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 Teaching Strategy It is in this section that students begin to see relationships between account categories and the financial health of a company. Although ratio analysis may be new to students, the math is simple. As each ratio is introduced, care should be taken to discuss the meaning behind it. Relate ratio analysis to industry averages as a measure of financial stability for an individual company. This section provides a good opportunity to refer students to the library or the Internet for some research into ratios of companies with which they are familiar. (Moody’s or Standard & Poor’s can be suggested as a resource.) Short Exercises 9 and 10, Exercises 10 through 12, and Cases 5 and 9 apply to this section. Supplement to Chapter 5: How to Read an Annual Report Summary Statement Financial statements of corporations are usually complicated and contain a number of features not found in a sole proprietorship’s or partnership’s statements. Published statements appear in the company’s annual report, a publication distributed to stockholders annually and accompanied by nonfinancial information as well. A company’s financial statements for consecutive periods presented side by side for comparison are called comparative financial statements. Consolidated financial statements are the combined statements of a company and its controlled subsidiaries. In addition to the statement of earnings (income statement), the balance sheet, and the statement of cash flows, a statement of stockholders’ equity often replaces the owner’s equity statement. A section called notes to the financial statements usually is needed to help the reader interpret some of the complex items contained in the financial statements. A summary of significant accounting policies discloses the GAAP used in preparing the statements. It usually follows the last financial statement, perhaps as the first note to the financial statements. Corporations frequently are required to issue interim financial statements consisting of financial information covering less than a year (e.g., quarterly). The registered independent auditors’ report is issued by an independent auditor. It conveys to third parties that the financial statements were examined in accordance with generally accepted auditing standards (scope section) and expresses the auditors’ opinion on how fairly the financial statements reflect the company’s financial condition (opinion section). The language of the accountants’ report emphasizes management’s responsibilities and clarifies the nature and purpose of an audit. An annual report also usually includes a report of management’s responsibilities as well as management’s discussion and analysis of operating performance.  Related Text Illustrations Exhibit S-1: CVS’s Income Statements Exhibit S-2: CVS’s Balance Sheets Exhibit S-3: CVS’s Statements of Shareholders’ Equity Exhibit S-4: CVS’s Statements of Cash Flows Figure S-1: Auditor’s Report for CVS Corporation The complete annual report for CVS Corporation and the financial statements with notes for Southwest Airlines Co. are both included in this section. Lecture Outline . 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. . 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. . 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. . An annual report usually includes a report of management’s responsibilities as well as management’s discussion and analysis of operations. Teaching Strategy Actual annual reports are effective teaching aids. In addition to using the examples in the text, bring several other annual reports to class, preferably from different companies and industries. They are readily available through corporations’ headquarters. They also can be viewed online in the investor relations section of most corporate websites. Point out the importance of each component in the reports.