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Chapter 4: Financial Reporting and Analysis I. Objective of Financial Reporting A.

To provide information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors B. Assess cash flow prospects C. Assess stewardship II. Qualitative Characteristics of Accounting Information A. Accounting is rarely as precise as found in textbooks B. qualitative characteristics FASB established standards to judge information C. relevance information has a direct bearing on the decision i. predictive value helps capital providers make decisions about the future ii. confirmative value helps determine if expectations have been met D. faithful representation financial reporting for an entity must be a reliable depiction of what it purports to represent i. Must be complete, neutral, and free from material error E. comparability the quality that enables users to identify similarities and differences between two sets of economic phenomena F. verifiability the quality that helps assure users that information faithfully represents what it purports to depict G. timeliness the quality that enables users to receive information in time to influence a decision H. understandability the quality that enables users to comprehend the meaning of the information they receive III. Accounting Conventions A. accounting conventions constraints on accounting B. Accountants must prepare information in accordance with accepted practices IV. Ethical Financial Reporting A. Fraudulent accounting practices have a high cost for investors, lenders, employees, and customers. V. 5 Accounting Conventions for Preparing Financial Statements A. Consistency i. consistency 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 chance in procedure ii. A note of change must contain the nature of and justification for the change B. Full Disclosure (Transparency) i. full disclosure/transparency financial statements must present all the information relevant to users' understand of the statements ii. explanatory notes are an integral part of accounting to prevent misleading information C. Materiality i. materiality refers to the relative importance of an item or event ii. An item is material if there is a reasonable expectation that knowing about it would influence the decisions of users of financial statements. iii. As a general rule, an item is considered material if it is worth 5 percent or more of net income D. Conservatism i. conservatism when faced with choosing between two equally acceptable procedures or

estimates, choose the one that is least likely to overstate assets or income E. Cost-Benefit i. cost-benefit the benefits to be gained from providing accounting information should be greater that the costs of providing it VI. Classified Balance Sheet A. classified financial statements external financial statements that are divided into subcategories B. Assets i. Assets divided into current assets; investments; property, plant, and equipment; and intangible assets. ii. These categories are listed in order by decreasing liquidity iii. Current Assets a) current assets cash and other assets that a company can reasonably expect to convert to cash, sell, or consume within one year b) normal operating cycle the average time a company needs to go from spending cash to receiving cash c) The normal operating cycle is usually less than a year, but some larger product companies (e.g. airplanes) may take longer d) Cash, short-term investments, notes and accounts receivable, inventory, prepaid expenses, and supplies are all current assets. iv. Investments a) investments includes 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. b) Securities held for long-term investment, long-term notes receivable, land held for future use, plant not used in the business, and special funds established to pay off a debt or buy a building are all investments v. Property, Plant, and Equipment a) property, plant, and equipment tangible long-term assets used in a business's dayto-day operations b) They represent both a place to operate and the equipment to produce, sell, and deliver goods or services. c) Also known as operating assets, fixed assets, tangible assets, long-lived assets, and plant assets. d) Also includes natural resources (e.g. forest lands, oil, and gas) owned by the company vi. Intangible Assets a) intangible assets long-term assets with no physical substance whose value stems from the rights or privileges they extend to their owners b) Patents, copyrights, goodwill, franchises, and trademark are all intangible assets. C. Liabilities i. Current Liabilities a) current liabilities obligations that must be satisfied within one year or within a company's normal operating cycle b) Notes payable, accounts payable, current portion of long-term debt, salaries and wages payable, taxes payable, and unearned revenue are all current liabilities ii. Long-Term Liabilities a) long-term liabilities debts that fall due more than one year in the future or beyond the normal operating cycle

b) Mortgages payable, long-term notes, bonds payable, employee pension obligations ,and long-term lease liabilities generally fall into this category D. Stockholders' Equity i. contributed capital stock and additional paid-in capital ii. Retained Earnings E. Owner's Equity and Partners' Equity i. Sole Proprietorship: Simply shows the capital in the owner's name at an amount equal to the net assets of the company (i.e. assets minus liabilities). ii. Partnership: Shows the capital in each partner's name, with a total partners' equity that is equal to the net assets of the company VII. Forms of the Income Statement A. Multistep Income Statement i. multistep income statement goes through a series of steps, or subtotals, to arrive at net income (pgs. 224,225) ii. Net Sales a) net sales the gross proceeds from sales less sales returns and allowances and any discounts allowed b) gross sales total cash sales and total credit sales during an accounting period c) sales returns and allowances cash refunds, credits on account, and discounts from selling prices made to customers who have received defective products or unsatisfactory products. iii. Cost of Goods Sold a) cost of goods sold an expense that is the amount a merchandiser paid for the merchandise it sold during an accounting period iv. Gross Margin a) gross margin the difference between net sales and cost of goods sold b) To be successful, a company's gross margin must cover operating expenses and provide adequate after-tax income v. Operating Expenses a) operating expenses expenses incurred in running a business other than the cost of goods sold vi. Income from Operations a) income from operations the difference between gross margin and operating expenses vii. Other Revenues and Expenses a) other revenues and expenses revenues and expenses not related to a company's operating activities b) Includes revenues from investments and interest earned on credit or notes extended to customers, and interest expense and other expenses from borrowing money viii. Income Before Income Taxes ix. Income Taxes Expense x. Net Income a) net income what remains of gross margin after operating expenses, other revenues and expenses, and income taxes xi. Earnings Per Share a) earnings per share the net income earned on each share of common stock B. Single-Step Income Statement i. Revenues ii. Costs and Expenses

iii. Income before Income Taxes a) income before income taxes revenues minus costs and expenses iv. Income Taxes Expense v. Net Income vi. Earnings per Share VIII. Using Classified Financial Statements A. Evaluation of Liquidity i. liquidity means having enough money on hand to pay bills when they are due and to take care of unexpected needs for cash ii. Working Capital a) working capital the amount by which current assets exceed current liabilities (i.e. current assets minus current liabilities) iii. Current Ratio a) current ratio current assets divided by current liabilities b) A good measure of a company's ability to pay its debts on time B. Evaluation of Profitability i. profitability the ability to earn a satisfactory income ii. Profit Margin a) profit margin Net Income divided by Net Sales b) Measures the percentage of each sales dollar that results in net income iii. Asset Turnover a) asset turnover Net Sales divided by Average Total Assets b) Measures how efficiently assets are used to produce sales iv. Return on Assets a) return on assets Net Income divided by Average Total Assets b) The percentage of income generated from each dollar invested in assets c) Also equal to Profit Margin time Asset Turnover v. Debt to Equity Ration a) debt to equity ratio Total Liabilities divided by Stockholders' Equity b) Shows the proportion of a company's finances that come from creditors and investors. vi. Return on Equity a) return on equity Net Income divided by Average Stockholders' Equity b) Shows income as a percentage of what is invested. vii.

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