Chapter 2: Financial StatementsChapter 2: Financial StatementsThe Classified Balance Sheet:o Presents a snapshot at a point in time.o To improve understanding, companies group similar assets and similar liabilities together. - Standard Classifications:o Assets: current assets, long-term investments, property, plant, equipment, and intangible assets. o Liabilities and Stockholders’ Equity: current liabilities, long-term liabilities, stockholders’ equity. - Current Assets: o Assets that a company expects to convert to cash or use up within one year or the operating cycle, whichever is longer.o Operating Cycle: the average time it takes from the purchase of inventory to the collection of cash from customers. o Common Types of current assets: 1. Cash, 2. Investments, 3. Receivables, 4. Inventories, and 5. Prepaid Expenses. oo Companies list current asset accounts in the order they expect to convert them into cash. - Long-Term Investments (Investments):o Investments in stocks and bonds of other corporations that are held for more than one year. o Long-term assets such as land or buildings that a company is not currently using in its operating activities. o Long-term notes receivable. - Property, Plant, and Equipment (Fixed Assets or Plants Assets):o Long useful lives.o Currently used in operations.o Includes land, buildings, equipment, delivery vehicles, and furniture.o Depreciation: allocating the cost of assets to a number of years. o Accumulated Depreciation: total amount of depreciation expensed thus far in the asset’s life. - Intangible Assets (Other Assets):o Assets that do not have physical substance.o Includes goodwill, patents, copyrights, and trademarks or trade names.- Current Liabilities:o Obligations the company is to pay within the next year or operating cycle, whichever is longer. o Common Examples are accounts payable, salaries and wages payable, notes payable, interest payable, and income taxes payable. 2o Also included as current liabilities are current maturities of long-term obligations-payments to be made with the next year on long-term obligations. - Long-Term Liabilities:o Obligations a company expects to pay after one year. o Include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities. - Stockholders’ Equity:o Common Stock: investments of assets into the business by the stockholders. o Retained Earnings: income retained for use in the business. Using the Financial Statements:- Ratio Analysis:o Expresses the relationship among selected items of financial statementdata. o Ratio: expresses the mathematical relationship between one quantity and another. o A single ratio by itself is not very meaningful.- Profitability Ratios: measure the income or operating success of a company for a given period of time. - Liquidity Ratios: measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. 3- Solvency Ratios: measure the ability of the company to survive over a long period of time.- Using the Statement of Stockholders’ Equity: most companies use a statement of stockholders’ equity, rather than a retained earnings statement, so that they can report all changes in stockholders’ equity accounts. - Free Cash Flow = Cash Provided by Operations – Capital Expenditures – Cash Dividends. Using the Income Statement:- Earnings Per Share (EPS): measures the net income earned on each shareof common stock. EPS = Net Income – Preferred Demands / Average Common Shares Outstanding.Using a Classified Balance Sheet:- Liquidity: the ability to pay obligations expected to become due within the next year or operating cycle. - Working Capital: is the difference between the amounts of current assetsand current liabilities. Working Capital = Current Assets – Current Liabilities.- Liquidity Ratios: measure the short-term ability to pay maturing obligations and to meet unexpected needs for cash. 4- Solvency: the ability to pay interest as it comes due and to repay the balance of a debt due at its maturity. - Solvency Ratios: measure the ability of the company to survive over a long period of time. o Some users evaluate solvency using a ratio of liabilities divided by stockholders’ equity. The higher this “debt to equity” ratio, the loweris a company’s solvency. - Debts to Assets Ratio: measures the percentage of total financing provided by creditors rather than stockholders. Financial Reporting Concepts:- Generally Accepted Accounting Principles (GAAP): a set of rules and practices, having substantial authoritative support, that the accounting profession recognizes as a general guide for financial reporting purposes. - Standard-Setting Bodies Determine These Guidelines:o Securities and Exchange Commission (SEC).o Financial Accounting Standards Board (FASB).o International Accounting Standards Board (IASB).o Public Company Accounting Oversight Board (PCAOB).o International Note: over 115 countries use international standards called IFRS.5- According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation. o Relevance: accounting information has relevance if it would make a difference in a business decision. Information is considered relevant if it provides information that has predictive value, that is, helps provide accurate expectations about the future, and has confirmatory value, that is, confirms or corrects prior expectations. Materiality is a company-specific aspect of relevance. An item is material when its sizemakes it likely to influence the decision of an investor or creditor.o Faithful Representation: information accurately depicts what really happened. To provide a faithful representation, information must be complete, neutral, and free from error. - Assumptions in Financial Reporting:o Monetary Unit: requires that only those things that can be expressed in money are included in the accounting records.o Economic Entity: states that every economic entity can be separately identified and accounted for. o Periodicity: states that the life of a business can be divided into artificial time periods. o Going Concern: the business will remain in operation for the foreseeable future. - Principles in Financial Reporting: o Measurement Principles: Historical Cost: dictates that companies record assets at their cost.  Fair Value: indicates that assets and liabilities should be reported atfair value (the