The current assets section of the balance sheet should include

A Further Look at Financial Statements

 CHAPTER PREVIEW 

If you are thinking of purchasing Best Buy stock, or any stock, how can you decide what the shares are worth? If you manage Columbia Sportswear's credit department, how should you determine whether to extend credit to a new customer? If you are a financial executive at Google, how do you decide whether your company is generating adequate cash to expand operations without borrowing? Your decision in each of these situations will be influenced by a variety of considerations. One of them should be your careful analysis of a company's financial statements. The reason: Financial statements offer relevant and reliable information, which will help you in your decision‐making.

In this chapter, we take a closer look at the balance sheet and introduce some useful ways for evaluating the information provided by the financial statements. We also examine the financial reporting concepts underlying the financial statements. We begin by introducing the classified balance sheet.

Just Fooling Around?

Few people could have predicted how dramatically the Internet would change the investment world. One of the most interesting results is how it has changed the way ordinary people invest their savings. More and more people are striking out on their own, making their own investment decisions.

Two early pioneers in providing investment information to the masses were Tom and David Gardner, brothers who created an online investor website called The Motley Fool. The name comes from Shakespeare's As You Like It. The fool in Shakespeare's play was the only one who could speak unpleasant truths to kings and queens without being killed. Tom and David view themselves as 21st‐century “fools,” revealing the “truths” of the stock market to the small investor, who they feel has been taken advantage of by Wall Street insiders. The Motley Fool's online bulletin board enables investors to exchange information and insights about companies.

Critics of these bulletin boards contend that they are simply high‐tech rumor mills that cause investors to bid up stock prices to unreasonable levels. For example, the stock of PairGain Technologies jumped 32% in a single day as a result of a bogus takeover rumor on an investment bulletin board. Some observers are concerned that small investors—ironically, the very people the Gardner brothers are trying to help—will be hurt the most by misinformation and intentional scams.

To show how these bulletin boards work, suppose that you had $10,000 to invest. You were considering Best Buy Company, the largest seller of electronics equipment in the United States. You scanned the Internet investment bulletin boards and found messages posted by two different investors. Here are excerpts from actual postings:

TMPVenus: “Where are the prospects for positive movement for this company? Poor margins, poor management, astronomical P/E!”

broachman: “I believe that this is a LONG TERM winner, and presently at a good price.”

One says sell, and one says buy. Whom should you believe? If you had taken “broachman's” advice and purchased the stock, the $10,000 you invested would have been worth over $300,000 five years later. Best Buy was one of America's best‐performing stocks during that period of time.

Rather than getting swept away by rumors, investors must sort out the good information from the bad. One thing is certain—as information services such as The Motley Fool increase in number, gathering information will become even easier. Evaluating it will be the harder task.

LEARNING OBJECTIVE 1

Identify the sections of a classified balance sheet.

In Chapter 1 , you learned that a balance sheet presents a snapshot of a company's financial position at a point in time. It lists individual asset, liability, and stockholders' equity items. However, to improve users' understanding of a company's financial position, companies often use a classified balance sheet instead. A classified balance sheet groups together similar assets and similar liabilities, using a number of standard classifications and sections. This is useful because items within a group have similar economic characteristics. A classified balance sheet generally contains the standard classifications listed in Illustration 2-1 .

Assets

Liabilities and Stockholders' Equity

Current assets

      Current liabilities

Long-term investments

      Long-term liabilities

Property, plant, and equipment

      Stockholders' equity

Intangible assets

ILLUSTRATION 2-1 Standard balance sheet classifications

These groupings help financial statement readers determine such things as (1) whether the company has enough assets to pay its debts as they come due, and (2) the claims of short‐ and long‐term creditors on the company's total assets. Many of these groupings can be seen in the balance sheet of Franklin Corporation shown in Illustration 2-2 . In the sections that follow, we explain each of these groupings.

FRANKLIN CORPORATION

Balance Sheet

October 31, 2017

Assets

Current assets

 Cash

$ 6,600

 Debt investments

2,000

 Accounts receivable

7,000

 Notes receivable

1,000

 Inventory

3,000

 Supplies

2,100

 Prepaid insurance

    400

  Total current assets

$22,100

Long-term investments

 Stock investments

5,200

 Investment in real estate

  2,000

7,200

Property, plant, and equipment

 Land

10,000

 Equipment

$24,000

 Less: Accumulated depreciation—equipment

  5,000

  19,000

29,000

Intangible assets

 Patents

  3,100

Total assets

$61,400

Liabilities and Stockholders' Equity

Current liabilities

 Notes payable

$11,000

 Accounts payable

2,100

 Unearned sales revenue

900

 Salaries and wages payable

1,600

 Interest payable

    450

  Total current liabilities

$16,050

Long-term liabilities

 Mortgage payable

10,000

 Notes payable

   1,300

  Total long-term liabilities

 11,300

      Total liabilities

27,350

Stockholders' equity

 Common stock

14,000

 Retained earnings

 20,050

      Total stockholders' equity

 34,050

Total liabilities and stockholders' equity

$61,400

ILLUSTRATION 2-2 Classified balance sheet

▼ HELPFUL HINT

Recall that the accounting equation is Assets=Liabilities+Stockholders' EquityRecall that the accounting equation is Assets=Liabilities+Stockholders' Equity.

CURRENT ASSETS

Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2-2 , Franklin Corporation had current assets of $22,100. For most businesses, the cutoff for classification as current assets is one year from the balance sheet date. For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use the supplies in operations within one year.

Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year. The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers. For most businesses, this cycle takes less than a year, so they use a one‐year cutoff. But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long‐term.

Common types of current assets are (1) cash, (2) investments (such as short‐term U.S. government securities), (3) receivables (accounts receivable, notes receivable, and interest receivable), (4) inventories, and (5) prepaid expenses (insurance and supplies). Companies list current assets in the order in which they expect to convert them into cash. Follow this rule when doing your homework.

Illustration 2-3 presents the current assets of Southwest Airlines Co. in a recent year.

SOUTHWEST AIRLINES CO.

Balance Sheet (partial)

(in millions)

Current assets

 Cash and cash equivalents

$1,355

 Short-term investments

1,797

 Accounts receivable

419

 Inventories

467

 Prepaid expenses and other current assets

   418

  Total current assets

$4,456

ILLUSTRATION 2-3 Current assets section

As explained later in the chapter, a company's current assets are important in assessing its short‐term debt‐paying ability.

LONG‐TERM INVESTMENTS

Long‐term investments are generally (1) investments in stocks and bonds of other corporations that are held for more than one year, (2) long‐term assets such as land or buildings that a company is not currently using in its operating activities, and (3) long‐term notes receivable. In Illustration 2-2 , Franklin Corporation reported total long‐term investments of $7,200 on its balance sheet.

Google Inc. reported long‐term investments on its balance sheet in a recent year as shown in Illustration 2-4 .

GOOGLE INC.

Balance Sheet (partial)

(in millions)

Long-term investments

 Non-marketable equity investments

$1,469

ILLUSTRATION 2-4 Long‐term investments section

ALTERNATIVE TERMINOLOGY

Long‐term investments are often referred to simply as investments.

PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business. This category includes land, buildings, equipment, delivery vehicles, and furniture. In Illustration 2-2 , Franklin Corporation reported property, plant, and equipment of $29,000.

Depreciation is the allocation of the cost of an asset to a number of years. Companies do this by systematically assigning a portion of an asset's cost as an expense each year (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset's life. In Illustration 2-2 , Franklin Corporation reported accumulated depreciation of $5,000.

Illustration 2-5 presents the property, plant, and equipment of Tesla Motors, Inc. in a recent year.

TESLA MOTORS, INC.

Balance Sheet (partial)

(in thousands)

Property, plant, and equipment

 Machinery, equipment and office furniture

$ 322,394 

 Tooling

230,385 

 Leasehold improvements

94,763 

 Building and building improvements

67,707 

 Land

45,020 

 Computer equipment and software

42,073 

 Construction in progress

   76,294 

878,636 

 Less: Accumulated depreciation and amortization

  (140,142)

 Total

$ 738,494 

ILLUSTRATION 2-5 Property, plant, and equipment section

ALTERNATIVE TERMINOLOGY

Property, plant, and equipment is sometimes called fixed assets or plant assets.

INTANGIBLE ASSETS

Many companies have assets that do not have physical substance and yet often are very valuable. We call these assets intangible assets . One common intangible is goodwill. Others include patents, copyrights, and trademarks or trade names that give the company exclusive right of use for a specified period of time. In Illustration 2-2 , Franklin Corporation reported intangible assets of $3,100.

Illustration 2-6 shows the intangible assets of media and theme park giant The Walt Disney Company in a recent year.

THE WALT DISNEY COMPANY

Balance Sheet (partial)

(in millions)

Intangible assets and goodwill

 Character/franchise intangibles and copyrights

$ 5,830 

 Other amortizable intangible assets

903 

 Accumulated amortization

 (1,204)

  Net amortizable intangible assets

5,529 

 FCC licenses

667 

 Trademarks

1,218 

 Other indefinite lived intangible assets

    20 

7,434 

 Goodwill

 27,881 

$35,315 

ILLUSTRATION 2-6 Intangible assets section

DO IT! 1a

Assets Section of Classified Balance Sheet

Baxter Hoffman recently received the following information related to Hoffman Corporation's December 31, 2017, balance sheet.

Prepaid insurance

$ 2,300

Inventory

$3,400

Cash

800

Accumulated depreciation—equipment

2,700

Equipment

10,700

Accounts receivable

1,100

Prepare the assets section of Hoffman Corporation's classified balance sheet.

Action Plan

✓ Present current assets first. Current assets are cash and other resources that the company expects to convert to cash or use up within one year.

✓ Present current assets in the order in which the company expects to convert them into cash.

✓ Subtract accumulated depreciation—equipment from equipment to determine net equipment.

SOLUTION

HOFFMAN CORPORATION

Balance Sheet (partial)

December 31, 2017

Assets

Current assets

 Cash

$  800

 Accounts receivable

1,100

 Inventory

3,400

 Prepaid insurance

  2,300

  Total current assets

$ 7,600

Property, plant, and equipment

 Equipment

10,700

 Less: Accumulated depreciation—equipment

  2,700

  8,000

Total assets

$15,600

Related exercise material: BE2-2, DO IT! 2-1a, E2-3, and E2-4.

▼ HELPFUL HINT

Sometimes intangible assets are reported under a broader heading called “Other assets.”

CURRENT LIABILITIES

In the liabilities and stockholders' equity section of the balance sheet, the first grouping is current liabilities. Current liabilities are obligations that the company is to pay within the next year or operating cycle, whichever is longer. Common examples are accounts payable, salaries and wages payable, notes payable, interest payable, and income taxes payable. Also included as current liabilities are current maturities of long‐term obligations—payments to be made within the next year on long‐term obligations. In Illustration 2-2 , Franklin Corporation reported five different types of current liabilities, for a total of $16,050.

Illustration 2-7 shows the current liabilities section adapted from the balance sheet of Google Inc. in a recent year.

GOOGLE INC.

Balance Sheet (partial)

(in millions)

Current liabilities

 Accounts payable

$ 2,012

 Short-term debt

2,549

 Accrued compensation and benefits

2,239

 Accrued expenses and other current liabilities

7,297

 Income taxes payable, net

   240

  Total current liabilities

$14,337

ILLUSTRATION 2-7 Current liabilities section

LONG‐TERM LIABILITIES

Long‐term liabilities (long‐term debt) are obligations that a company expects to pay after one year. Liabilities in this category include bonds payable, mortgages payable, long‐term notes payable, lease liabilities, and pension liabilities. Many companies report long‐term debt maturing after one year as a single amount in the balance sheet and show the details of the debt in notes that accompany the financial statements. Others list the various types of long‐term liabilities. In Illustration 2-2 , Franklin Corporation reported long‐term liabilities of $11,300.

Illustration 2-8 shows the long‐term liabilities that Nike, Inc. reported in its balance sheet in a recent year.

NIKE, INC.

Balance Sheet (partial)

(in millions)

Long-term liabilities

 Bonds payable

$1,106

 Notes payable

51

 Deferred income taxes and other

 1,544

  Total long-term liabilities

$2,701

ILLUSTRATION 2-8 Long‐term liabilities section

STOCKHOLDERS' EQUITY

Stockholders' equity consists of two parts: common stock and retained earnings. Companies record as common stock the investments of assets into the business by the stockholders. They record as retained earnings the income retained for use in the business. These two parts, combined, make up stockholders' equity on the balance sheet. In Illustration 2-2 , Franklin Corporation reported common stock of $14,000 and retained earnings of $20,050.

ALTERNATIVE TERMINOLOGY

Common stock is sometimes called capital stock.

DO IT! 1b

Balance Sheet Classifications

The following financial statement items were taken from the financial statements of Callahan Corp.

1. ________ Salaries and wages payable

2. ________ Service revenue

3. ________ Interest payable

4. ________ Goodwill

5. ________ Debt investments (short‐term)

6. ________ Mortgage payable (due in 3 years)

7. ________ Investment in real estate

8. ________ Equipment

9. ________ Accumulated depreciation—equipment

10. ________ Depreciation expense

11. ________ Retained earnings

12. ________ Unearned service revenue

Match each of the items to its proper balance sheet classification, shown below. If the item would not appear on a balance sheet, use “NA.”

1. Current assets (CA)

2. Long‐term investments (LTI)

3. Property, plant, and equipment (PPE)

4. Intangible assets (IA)

5. Current liabilities (CL)

6. Long‐term liabilities (LTL)

7. Stockholders' equity (SE)

Action Plan

✓ Analyze whether each financial statement item is an asset, liability, or stockholders' equity item.

✓ Determine if asset and liability items are current or long‐term.

SOLUTION

CL

Salaries and wages payable

NA

Service revenue

CL

Interest payable

IA

Goodwill

CA

Debt investments (short‐term)

LTL

Mortgage payable (due in 3 years)

LTI

Investment in real estate

PPE

Equipment

PPE

Accumulated depreciation—equipment

NA

Depreciation expense

SE

Retained earnings

CL

Unearned service revenue

Related exercise material: BE2-1, DO IT! 2-1b, E2-1, E2-2, E2-3, E2-5, and E2-6.

LEARNING OBJECTIVE 2

Use ratios to evaluate a company's profitability, liquidity, and solvency.

In Chapter 1 , we introduced the four financial statements. We discussed how these statements provide information about a company's performance and financial position. In this chapter, we extend this discussion by showing you specific tools that you can use to analyze financial statements in order to make a more meaningful evaluation of a company.

RATIO ANALYSIS

Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. For analysis of the primary financial statements, we classify ratios as shown in Illustration 2-9 .

ILLUSTRATION 2-9 Financial ratio classifications

A single ratio by itself is not very meaningful. Accordingly, in this and the following chapters, we will use various comparisons to shed light on company performance:

1. Intracompany comparisons covering two years for the same company.

2. Industry‐average comparisons based on average ratios for particular industries.

3. Intercompany comparisons based on comparisons with a competitor in the same industry.

Next, we use some ratios and comparisons to analyze the financial statements of Best Buy.

USING THE INCOME STATEMENT

Best Buy generates profits for its stockholders by selling electronics. The income statement reveals how successful the company is at generating a profit from its sales. The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses). Illustration 2-10 shows a simplified income statement for Best Buy.

BEST BUY CO., INC.

Income Statements

For the 12 Months Ended February 1, 2014,

and 11 Months Ended February 2, 2013 (in millions)

 2014 

 2013 

Revenues

Net sales and other revenue

$42,410

$39,827 

Expenses

Cost of goods sold

32,720

30,528 

Selling, general, and administrative expenses and other

8,760

9,471 

Income tax expense

    398

    269 

Total expenses

 41,878

 40,268 

Net income/(loss)

$   532

$  (441)

ILLUSTRATION 2-10 Best Buy's income statement

From this income statement, we can see that Best Buy's sales and net income increased during the period. Net income increased from a $441 million loss to a positive $532 million. One extremely unusual aspect of Best Buy's income statement is that the 2013 comparative column only covers 11 months. This occurred because Best Buy changed its year‐end from “the Saturday nearest the end of February to the Saturday nearest the end of January.” Such a change is very uncommon and complicates efforts to compare performance across years.

A much smaller competitor of Best Buy is hhgregg. hhgregg operates 228 stores in 20 states and is headquartered in Indianapolis, Indiana. It reported net income of $228,000 for the year ended March 31, 2014.

To evaluate the profitability of Best Buy, we will use ratio analysis. Profitability ratios , such as earnings per share, measure the operating success of a company for a given period of time.

Earnings per Share

Earnings per share (EPS) measures the net income earned on each share of common stock. Stockholders usually think in terms of the number of shares they own or plan to buy or sell, so stating net income earned as a per share amount provides a useful perspective for determining the investment return. Advanced accounting courses present more refined techniques for calculating earnings per share.

For now, a basic approach for calculating earnings per share is to divide earnings available to common stockholders by weighted‐average common shares outstanding during the year. What is “earnings available to common stockholders”? It is an earnings amount calculated as net income less dividends paid on another type of stock, called preferred stock (Net income−Preferred dividends)(Net income−Preferred dividends).

DECISION TOOLS

Earnings per share helps users compare a company's performance with that of previous years.

By comparing earnings per share of a single company over time, we can evaluate its relative earnings performance from the perspective of a stockholder—that is, on a per share basis. It is very important to note that comparisons of earnings per share across companies are not meaningful because of the wide variations in the numbers of shares of outstanding stock among companies.

Illustration 2-11 shows the earnings per share calculation for Best Buy in 2014 and 2013, based on the information presented below. Recall that Best Buy's 2013 income is based on 11 months of results. Further, to simplify our calculations, we assumed that any change in the number of shares for Best Buy occurred in the middle of the year.

(in millions)

2014

2013

Net income (loss)

$532

$(441)

Preferred dividends

–0–

–0– 

Shares outstanding at beginning of year

338

341 

Shares outstanding at end of year

347

338 

ILLUSTRATION 2-11 Best Buy's earnings per share

USING A CLASSIFIED BALANCE SHEET

You can learn a lot about a company's financial health by also evaluating the relationship between its various assets and liabilities. Illustration 2-12 provides a simplified balance sheet for Best Buy.

BEST BUY CO., INC.

Balance Sheets

(in millions)

Assets

February 1, 2014

February 2, 2013

Current assets

 Cash and cash equivalents

$  2,678   

$  1,826   

 Short-term investments

223   

0   

 Receivables

1,308   

2,704   

 Merchandise inventories

5,376   

6,571   

 Other current assets

    900   

    946   

  Total current assets

 10,485   

 12,047   

Property and equipment

7,575   

8,375   

Less: Accumulated depreciation

  4,977   

  5,105   

  Net property and equipment

  2,598   

  3,270   

Other assets

    930   

  1,470   

Total assets

$14,013   

$16,787   

Liabilities and Stockholders' Equity

Current liabilities

 Accounts payable

$  5,122   

$  6,951   

 Accrued liabilities

873   

1,188   

 Accrued income taxes

147   

129   

 Accrued compensation payable

444   

520   

 Other current liabilities

    850   

  2,022   

  Total current liabilities

  7,436   

 10,810   

Long-term liabilities

 Long-term debt

976   

1,109   

 Other long-term liabilities

  1,612   

  1,153   

  Total long-term liabilities

  2,588   

  2,262   

      Total liabilities

 10,024   

 13,072   

Stockholders' equity

 Common stock

335   

88   

 Retained earnings and other

  3,654   

  3,627   

      Total stockholders' equity

  3,989   

  3,715   

Total liabilities and stockholders' equity

$14,013   

$16,787   

ILLUSTRATION 2-12 Best Buy's balance sheet

Liquidity

Suppose you are a banker at CitiGroup considering lending money to Best Buy, or you are a sales manager at Hewlett‐Packard interested in selling computers to Best Buy on credit. You would be concerned about Best Buy's liquidity —its ability to pay obligations expected to become due within the next year or operating cycle. You would look closely at the relationship of its current assets to current liabilities.

WORKING CAPITAL One measure of liquidity is working capital , which is the difference between the amounts of current assets and current liabilities:

Working Capital=Current Assets−Current LiabilitiesWorking Capital=Current Assets−Current Liabilities

ILLUSTRATION 2-13 Working capital

When current assets exceed current liabilities, working capital is positive. When this occurs, there is a greater likelihood that the company will pay its liabilities. When working capital is negative, a company might not be able to pay short‐term creditors, and the company might ultimately be forced into bankruptcy. Best Buy had working capital in 2014 of $3,049 million ($10,485 million−$7,436 million)($10,485 million−$7,436 million).

CURRENT RATIO Liquidity ratios measure the short‐term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. One liquidity ratio is the current ratio , computed as current assets divided by current liabilities.

DECISION TOOLS

The current ratio helps users determine if a company can meet its near‐term obligations.

The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have significantly different current ratios. Illustration 2-14 shows the 2014 and 2013 current ratios for Best Buy and for hhgregg, along with the 2014 industry average.

ILLUSTRATION 2-14 Current ratio

What does the ratio actually mean? Best Buy's 2014 current ratio of 1.41:1 means that for every dollar of current liabilities, Best Buy has $1.41 of current assets. Best Buy's current ratio increased in 2014. When compared to the industry average of .88:1, Best Buy's liquidity seems strong. It is lower than hhgregg's but not significantly so.

One potential weakness of the current ratio is that it does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose whether a portion of the current assets is tied up in slow‐moving inventory. The composition of the current assets matters because a dollar of cash is more readily available to pay the bills than is a dollar of inventory. For example, suppose a company's cash balance declined while its merchandise inventory increased substantially. If inventory increased because the company is having difficulty selling its products, then the current ratio might not fully reflect the reduction in the company's liquidity.

ETHICS NOTE

A company that has more current assets than current liabilities can increase the ratio of current assets to current liabilities by using cash to pay off some current liabilities. This gives the appearance of being more liquid. Do you think this move is ethical?

 ACCOUNTING ACROSS THE ORGANIZATION 

REL Consultancy Group

Can a Company Be Too Liquid?

There actually is a point where a company can be too liquid—that is, it can have too much working capital. While it is important to be liquid enough to be able to pay short‐term bills as they come due, a company does not want to tie up its cash in extra inventory or receivables that are not earning the company money.

By one estimate from the REL Consultancy Group, the thousand largest U.S. companies had cumulative excess working capital of $1.017 trillion in a recent year. This was an 18% increase, which REL said represented a “deterioration in the management of operations.” Given that managers throughout a company are interested in improving profitability, it is clear that they should have an eye toward managing working capital. They need to aim for a “Goldilocks solution”—not too much, not too little, but just right.

Source: Maxwell Murphy, “The Big Number,” Wall Street Journal (November 9, 2011).

What can various company managers do to ensure that working capital is managed efficiently to maximize net income? (Go to WileyPLUS for this answer and additional questions.)

Solvency

Now suppose that instead of being a short‐term creditor, you are interested in either buying Best Buy's stock or extending the company a long‐term loan. Long‐term creditors and stockholders are interested in a company's solvency —its 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.

DEBT TO ASSETS RATIO The debt to assets ratio is one measure of solvency. It is calculated by dividing total liabilities (both current and long‐term) by total assets. It measures the percentage of total financing provided by creditors rather than stockholders. Debt financing is more risky than equity financing because debt must be repaid at specific points in time, whether the company is performing well or not. Thus, the higher the percentage of debt financing, the riskier the company.

▼ HELPFUL HINT

Some users evaluate solvency using a ratio of liabilities divided by stockholders' equity. The higher this “debt to equity” ratio, the lower is a company's solvency.

The higher the percentage of total liabilities (debt) to total assets, the greater the risk that the company may be unable to pay its debts as they come due. Illustration 2-15 shows the debt to assets ratios for Best Buy and hhgregg, along with the industry average.

ILLUSTRATION 2-15 Debt to assets ratio

The 2014 ratio of 72% means that every dollar of assets was financed by 72 cents of debt. Best Buy's ratio is less than the industry average of 88% and is significantly higher than hhgregg's ratio of 51%. The higher the ratio, the more reliant the company is on debt financing. This means that Best Buy has a lower equity “buffer” available to creditors if the company becomes insolvent when compared to hhgregg. Thus, from the creditors' point of view, a high ratio of debt to assets is undesirable. Best Buy's solvency appears lower than hhgregg's and higher than the average company in the industry.

The adequacy of this ratio is often judged in light of the company's earnings. Generally, companies with relatively stable earnings, such as public utilities, can support higher debt to assets ratios than can cyclical companies with widely fluctuating earnings, such as many high‐tech companies. In later chapters, you will learn additional ways to evaluate solvency.

DECISION TOOLS

The debt to assets ratio helps users determine if a company can meet its long‐term obligations.

INVESTOR INSIGHT

When Debt Is Good

Debt financing differs greatly across industries and companies. Here are some debt to assets ratios for selected companies in a recent year:

Debt to Assets Ratio

Google

23%

Nike

41%

Microsoft

48%

ExxonMobil

48%

General Motors

74%

Discuss the difference in the debt to assets ratio of Microsoft and General Motors. (Go to WileyPLUS for this answer and additional questions.)

USING THE STATEMENT OF CASH FLOWS

In the statement of cash flows, net cash provided by operating activities is intended to indicate the cash‐generating capability of the company. Analysts have noted, however, that net cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment (capital expenditures) just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. A measurement to provide additional insight regarding a company's cash‐generating ability is free cash flow. Free cash flow describes the net cash provided by operating activities after adjusting for capital expenditures and dividends paid.

Consider the following example. Suppose that MPC produced and sold 10,000 personal computers this year. It reported $100,000 net cash provided by operating activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash flow was $80,000 ($100,000−$15,000−$5,000)$80,000 ($100,000−$15,000−$5,000). The company could use this $80,000 to purchase new assets to expand the business, pay off debts, or increase its dividend distribution. In practice, analysts often calculate free cash flow with the formula shown in Illustration 2-16 . (Alternative definitions also exist.)

DECISION TOOLS

Free cash flow helps users determine the amount of cash a company generated to expand operations, pay off debts, or increase dividends.

Free CashFlow=Net Cash Providedby Operating Activities−CapitalExpenditures−CashDividendsFree CashFlow=Net Cash Providedby Operating Activities−CapitalExpenditures−CashDividends

ILLUSTRATION 2-16 Free cash flow

We can calculate Best Buy's 2014 free cash flow as shown in Illustration 2-17 (dollars in millions).

Net cash provided by operating activities

$1,094

Less: Expenditures on property, plant, and equipment

547

   Dividends paid

   233

Free cash flow

$  314

ILLUSTRATION 2-17 Best Buy's free cash flow

Best Buy generated free cash flow of $314 million, which is available for the acquisition of new assets, the retirement of stock or debt, or the payment of additional dividends. Long‐term creditors consider a high free cash flow amount an indication of solvency. hhgregg's free cash flow for 2014 is $60 million. Given that hhgregg is considerably smaller than Best Buy, we would expect its free cash flow to be much lower.

DO IT! 2

Ratio Analysis

The following information is available for Ozone Inc.

2017

2016

Current assets

$ 88,000

$ 60,800

Total assets

400,000

341,000

Current liabilities

40,000

38,000

Total liabilities

120,000

150,000

Net income

100,000

50,000

Net cash provided by operating activities

110,000

70,000

Preferred dividends

10,000

10,000

Common dividends

5,000

2,500

Expenditures on property, plant, and equipment

45,000

20,000

Shares outstanding at beginning of year

60,000

40,000

Shares outstanding at end of year

120,000

60,000

(a) Compute earnings per share for 2017 and 2016 for Ozone, and comment on the change. Ozone's primary competitor, Frost Corporation, had earnings per share of $2 in 2017. Comment on the difference in the ratios of the two companies.

(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.

(c) Compute free cash flow for each year, and comment on the changes.

Action Plan

✓ Use the formula for earnings per share (EPS): (Net income−Preferred dividends)÷Weighted‐average common shares outstanding(Net income−Preferred dividends)÷Weighted‐average common shares outstanding.

✓ Use the formula for the current ratio: Current assets÷Current liabilitiesCurrent assets÷Current liabilities.

✓ Use the formula for the debt to assets ratio: Total liabilities÷Total assetsTotal liabilities÷Total assets.

✓ Use the formula for free cash flow: Net cash provided by operating activities−Capital expenditures−Cash dividendsNet cash provided by operating activities−Capital expenditures−Cash dividends.

SOLUTION

(a) Earnings per share

2017

2016

($100,000−$10,000)(120,000+60,000)/2=$1.00($100,000−$10,000)(120,000+60,000)/2=$1.00

($50,000−$10,000)(60,000+40,000)/2=$0.80($50,000−$10,000)(60,000+40,000)/2=$0.80

  Ozone's profitability, as measured by the amount of income available to each share of common stock, increased by 25% [($1.00−$0.80)÷$0.80]25% [($1.00−$0.80)÷$0.80] during 2017. Earnings per share should not be compared across companies because the number of shares issued by companies varies widely. Thus, we cannot conclude that Frost Corporation is more profitable than Ozone based on its higher EPS.

(b)

      2017      

      2016      

Current ratio

 $88,000$40,000=2.20:1$88,000$40,000=2.20:1

 $60,800$38,000=1.60:1$60,800$38,000=1.60:1

Debt to assets ratio

$120,000$400,000=30%$120,000$400,000=30%

$150,000$341,000=44%$150,000$341,000=44%

  The company's liquidity, as measured by the current ratio, improved from 1.60:1 to 2.20:1. Its solvency also improved, as measured by the debt to assets ratio, which declined from 44% to 30%.

(c) Free cash flow

2017:$110,000−$45,000−($10,000+$5,000)=$50,0002016:$70,000−$20,000−($10,000+$2,500)=$37,5002017:$110,000−$45,000−($10,000+$5,000)=$50,0002016:$70,000−$20,000−($10,000+$2,500)=$37,500

   The amount of cash generated by the company above its needs for dividends and capital expenditures increased from $37,500 to $50,000.

Related exercise material: BE2-3, BE2-4, BE2-5, DO IT! 2-2, E2-7, E2-9, E2-10, and E2-11.

LEARNING OBJECTIVE 3

Discuss financial reporting concepts.

You have now learned about the four financial statements and some basic ways to interpret those statements. In this last section, we will discuss concepts that underlie these financial statements. It would be unwise to make business decisions based on financial statements without understanding the implications of these concepts.

THE STANDARD‐SETTING ENVIRONMENT

How does Best Buy decide on the type of financial information to disclose? What format should it use? How should it measure assets, liabilities, revenues, and expenses? Accounting professionals at Best Buy and all other U.S. companies get guidance from a set of accounting standards that have authoritative support, referred to as generally accepted accounting principles (GAAP) . Standard‐setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards.

The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. financial markets and accounting standard‐setting bodies. The Financial Accounting Standards Board (FASB) is the primary accounting standard‐setting body in the United States. The International Accounting Standards Board (IASB) issues standards called International Financial Reporting Standards (IFRS) , which have been adopted by many countries outside of the United States. Today, the FASB and IASB are working closely together to minimize the differences in their standards. Recently, the SEC announced that foreign companies that wish to have their shares traded on U.S stock exchanges no longer have to prepare reports that conform with GAAP, as long as their reports conform with IFRS. The SEC is currently evaluating whether the United States should eventually adopt IFRS as the required set of standards for U.S. publicly traded companies. Another relatively recent change to the financial reporting environment was that, as a result of the Sarbanes‐Oxley Act, the Public Company Accounting Oversight Board (PCAOB) was created. Its job is to determine auditing standards and review the performance of auditing firms. If the United States adopts IFRS for its accounting standards, it will also have to coordinate its auditing regulations with those of other countries.

INTERNATIONAL INSIGHT

The Korean Discount

If you think that accounting standards don't matter, consider recent events in South Korea. For many years, international investors complained that the financial reports of South Korean companies were inadequate and inaccurate. Accounting practices there often resulted in huge differences between stated revenues and actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of comparable companies in different countries. This difference in share price was often referred to as the “Korean discount.”

In response, Korean regulators decided that companies would have to comply with international accounting standards. This change was motivated by a desire to “make the country's businesses more transparent” in order to build investor confidence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international standards or to create standards that are based on the international standards.

Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).

What is meant by the phrase “make the country's businesses more transparent”? Why would increasing transparency spur economic growth? (Go to WileyPLUS for this answer and additional questions.)

INTERNATIONAL NOTE

Over 115 countries use international standards (called IFRS). For example, all companies in the European Union follow IFRS. In this textbook, we highlight any significant differences using International Notes like this one, as well as a more in‐depth discussion in the A Look at IFRS section at the end of each chapter.

QUALITIES OF USEFUL INFORMATION

Recently, the FASB and IASB completed the first phase of a joint project in which they developed a conceptual framework to serve as the basis for future accounting standards. The framework begins by stating that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 2-18 (page 60).

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 size makes it likely to influence the decision of an investor or creditor.

Faithful Representation Faithful representation means that information accurately depicts what really happened. To provide a faithful representation, information must be complete (nothing important has been omitted), neutral (is not biased toward one position or another), and free from error.

ILLUSTRATION 2-18 Fundamental qualities of useful information

Enhancing Qualities

In addition to the two fundamental qualities, the FASB and IASB also describe a number of enhancing qualities of useful information. These include comparability, verifiability, timeliness, and understandability. In accounting, comparability results when different companies use the same accounting principles. Another type of comparability is consistency. Consistency means that a company uses the same accounting principles and methods from year to year. Information is verifiable if independent observers, using the same methods, obtain similar results. As noted in Chapter 1 , certified public accountants (CPAs) perform audits of financial statements to verify their accuracy. For accounting information to have relevance, it must be timely . That is, it must be available to decision‐makers before it loses its capacity to influence decisions. The SEC requires that large public companies provide their annual reports to investors within 60 days of their year‐end. Information has the quality of understandability if it is presented in a clear and concise fashion, so that reasonably informed users of that information can interpret it and comprehend its meaning.

 ACCOUNTING ACROSS THE ORGANIZATION 

What Do These Companies Have in Common?

Another issue related to comparability is the accounting time period. An accounting period that is one‐year long is called a fiscal year. But a fiscal year need not match the calendar year. For example, a company could end its fiscal year on April 30 rather than on December 31.

Why do companies choose the particular year‐ends that they do? For example, why doesn't every company use December 31 as its accounting year‐end? Many companies choose to end their accounting year when inventory or operations are at a low point. This is advantageous because compiling accounting information requires much time and effort by managers, so they would rather do it when they aren't as busy operating the business. Also, inventory is easier and less costly to count when its volume is low.

Some companies whose year‐ends differ from December 31 are Delta Air Lines, June 30; The Walt Disney Company, September 30; and Dunkin' Donuts, Inc., October 31. In the notes to its financial statements, Best Buy states that its accounting year‐end is the Saturday nearest the end of January.

What problems might Best Buy's year‐end create for analysts? (Go to WileyPLUS for this answer and additional questions.)

ASSUMPTIONS IN FINANCIAL REPORTING

To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 2-19 . These include assumptions about the monetary unit, economic entity, periodicity, and going concern.

Monetary Unit Assumption The monetary unit assumption requires that only those things that can be expressed in money are included in the accounting records. This means that certain important information needed by investors, creditors, and managers, such as customer satisfaction, is not reported in the financial statements. This assumption relies on the monetary unit remaining relatively stable in value.

Economic Entity Assumption The economic entity assumption states that every economic entity can be separately identified and accounted for. In order to assess a company's performance and financial position accurately, it is important to not blur company transactions with personal transactions (especially those of its managers) or transactions of other companies.

Periodicity Assumption Notice that the income statement, retained earnings statement, and statement of cash flows all cover periods of one year, and the balance sheet is prepared at the end of each year. The periodicity assumption states that the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business.

Going Concern Assumption The going concern assumption states that the business will remain in operation for the foreseeable future. Of course, many businesses do fail, but in general it is reasonable to assume that the business will continue operating.

ILLUSTRATION 2-19 Key assumptions in financial reporting

ETHICS NOTE

The importance of the economic entity assumption is illustrated by scandals involving Adelphia. In this case, senior company employees entered into transactions that blurred the line between the employees' financial interests and those of the company. For example, Adelphia guaranteed over $2 billion of loans to the founding family.

PRINCIPLES IN FINANCIAL REPORTING

Measurement Principles

GAAP generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade‐offs between relevance and faithful representation.

HISTORICAL COST PRINCIPLE The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. For example, if land that was purchased for $30,000 increases in value to $40,000, it continues to be reported at $30,000.

FAIR VALUE PRINCIPLE The fair value principle indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets. In choosing between cost and fair value, the FASB uses two qualities that make accounting information useful for decision‐making—relevance and faithful representation. In determining which measurement principle to use, the FASB weighs the factual nature of cost figures versus the relevance of fair value. In general, the FASB indicates that most assets must follow the historical cost principle because market values may not be representationally faithful. Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied.

Full Disclosure Principle

The full disclosure principle requires that companies disclose all circumstances and events that would make a difference to financial statement users. If an important item cannot reasonably be reported directly in one of the four types of financial statements, then it should be discussed in notes that accompany the statements.

COST CONSTRAINT

Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard‐setters consider the cost constraint . It weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.