Us firms clash over accounting rules

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2

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 �inancial 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 in�luenced by a variety of considerations. One of them should be your careful analysis of a company's �inancial 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 �inancial statements. We also examine the �inancial reporting concepts underlying the �inancial statements. We begin by introducing the classi�ied balance sheet.

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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 �ive years later. Best Buy was one of America's best-performing stocks during that period of time.

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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.

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LEARNING OBJECTIVE 1

Identify the sections of a classi�ied balance sheet. 

In Chapter 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) , you learned that a balance sheet presents a snapshot of a company's �inancial position at a point in time. It lists individual asset, liability, and stockholders' equity items. However, to improve users' understanding of a company's �inancial position, companies often use a classi�ied balance sheet instead. A classi�ied balance sheet groups together similar assets and similar liabilities, using a number of standard classi�ications and sections. This is useful because items within a group have similar economic characteristics. A classi�ied balance sheet generally contains the standard classi�ications listed in Illustration 2-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0001) .

ILLUSTRATION 2-1 Standard balance sheet classi�ications

These groupings help �inancial 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) on the next page. In the sections that follow, we explain each of these groupings.

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ILLUSTRATION 2-2 Classi�ied balance sheet

▼ HELPFUL HINT

Recall 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) , Franklin

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Corporation had current assets of $22,100. For most businesses, the cutoff for classi�ication 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0003) presents the current assets of Southwest Airlines Co. in a recent year.

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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) , 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0004) .

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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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig- 0002) , 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) , Franklin Corporation reported accumulated depreciation of $5,000.

Illustration 2-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0005) presents the property, plant, and equipment of Tesla Motors, Inc. in a recent year.

ILLUSTRATION 2-5 Property, plant, and equipment section

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ALTERNATIVE TERMINOLOGY

Property, plant, and equipment is sometimes called �ixed 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 speci�ied period of time. In Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02- �ig-0002) , Franklin Corporation reported intangible assets of $3,100.

Illustration 2-6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0006) shows the intangible assets of media and theme park giant The Walt Disney Company in a recent year.

ILLUSTRATION 2-6 Intangible assets section

DO IT! 1a

Assets Section of Classi�ied 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

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Equipment 10,700 Accounts receivable 1,100

Prepare the assets section of Hoffman Corporation's classi�ied balance sheet.

Action Plan ✓ Present current assets �irst. 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

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.”

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CURRENT LIABILITIES In the liabilities and stockholders' equity section of the balance sheet, the �irst 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig- 0002) , Franklin Corporation reported �ive different types of current liabilities, for a total of $16,050.

Illustration 2-7 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0007) shows the current liabilities section adapted from the balance sheet of Google Inc. in a recent year.

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 �inancial statements. Others list the various types of long-term liabilities. In Illustration 2-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) , Franklin Corporation reported long-term liabilities of $11,300.

Illustration 2-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0008) shows the long-term liabilities that Nike, Inc. reported in its balance sheet in a recent year.

ILLUSTRATION 2-8 Long-term liabilities section

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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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo1#c02-�ig-0002) , Franklin Corporation reported common stock of $14,000 and retained earnings of $20,050.

DO IT! 1b

Balance Sheet Classi�ications

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

_______ Salaries and wages payable

_______ Service revenue

_______ Interest payable

_______ Goodwill

_______ Debt investments (short-term)

_______ Mortgage payable (due in 3 years)

_______ Investment in real estate

_______ Equipment

_______ Accumulated depreciation—equipment

_______ Depreciation expense

_______ Retained earnings

_______ Unearned service revenue

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

Current assets (CA)

Long-term investments (LTI)

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Property, plant, and equipment (PPE)

Intangible assets (IA)

Current liabilities (CL)

Long-term liabilities (LTL)

Stockholders' equity (SE)

Action Plan ✓ Analyze whether each �inancial 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.

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ALTERNATIVE TERMINOLOGY

Common stock is sometimes called capital stock.

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LEARNING OBJECTIVE 2

Use ratios to evaluate a company's pro�itability, liquidity, and solvency. 

In Chapter 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) , we introduced the four �inancial statements. We discussed how these statements provide information about a company's performance and �inancial position. In this chapter, we extend this discussion by showing you speci�ic tools that you can use to analyze �inancial statements in order to make a more meaningful evaluation of a company.

RATIO ANALYSIS Ratio analysis expresses the relationship among selected items of �inancial statement data. A ratio expresses the mathematical relationship between one quantity and another. For analysis of the primary �inancial statements, we classify ratios as shown in Illustration 2-9 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0009) (page 52).

ILLUSTRATION 2-9 Financial ratio classi�ications

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.

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

USING THE INCOME STATEMENT Best Buy generates pro�its for its stockholders by selling electronics. The income statement reveals how successful the company is at generating a pro�it 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0010) shows a simpli�ied income statement for Best Buy.

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 pro�itability of Best Buy, we will use ratio analysis. Pro�itability 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 re�ined 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

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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).

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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0011) 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.

ILLUSTRATION 2-11 Best Buy's earnings per share

DECISION TOOLS

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

USING A CLASSIFIED BALANCE SHEET You can learn a lot about a company's �inancial health by also evaluating the relationship between its various assets and liabilities. Illustration 2-12 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0012) (page 54) provides a simpli�ied balance sheet for Best Buy.

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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:

ILLUSTRATION 2-13 Working capital

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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).

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.

The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have signi�icantly different current ratios. Illustration 2-14 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0014) 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 signi�icantly 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 dif�iculty selling its products, then the current ratio might not fully re�lect the reduction in the company's liquidity.

 ACCOUNTING ACROSS THE ORGANIZATION 

REL Consultancy Group

Can a Company Be Too Liquid?

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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 pro�itability, 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 ef�iciently to maximize net income? (Go to WileyPLUS for this answer and additional questions.)

DECISION TOOLS

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

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?

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.

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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 �inancing provided by creditors rather than stockholders. Debt �inancing is more risky than equity �inancing because debt must be repaid at speci�ic points in time, whether the company is performing well or not. Thus, the higher the percentage of debt �inancing, the riskier the company.

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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0015) 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 �inanced by 72 cents of debt. Best Buy's ratio is less than the industry average of 88% and is signi�icantly higher than hhgregg's ratio of 51%. The higher the ratio, the more reliant the company is on debt �inancing. 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 �luctuating earnings, such as many high-tech companies. In later chapters, you will learn additional ways to evaluate solvency.

INVESTOR INSIGHT   When Debt Is Good

Debt �inancing 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%

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Debt to Assets Ratio

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.)

▼ 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.

DECISION TOOLS

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

USING THE STATEMENT OF CASH FLOWS In the statement of cash �lows, 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 �low. Free cash �low 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 �low was $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 �low with the formula shown in Illustration 2-16

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(http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0016) . (Alternative de�initions also exist.)

ILLUSTRATION 2-16 Free cash �low

We can calculate Best Buy's 2014 free cash �low as shown in Illustration 2-17 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo2#c02-�ig-0017) (dollars in millions).

ILLUSTRATION 2-17 Best Buy's free cash �low

Best Buy generated free cash �low 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 �low amount an indication of solvency. hhgregg's free cash �low for 2014 is $60 million. Given that hhgregg is considerably smaller than Best Buy, we would expect its free cash �low to be much lower.

DECISION TOOLS

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

DO IT! 2

Ratio Analysis

The following information is available for Ozone Inc.

2017 2016 Current assets $ 88,000 $ 60,800

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2017 2016

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 �low 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.

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

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

✓ Use the formula for free cash �low: Net cash provided by operating activities – Capital expenditures – Cash dividends.

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

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LEARNING OBJECTIVE 3

Discuss �inancial reporting concepts. 

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

THE STANDARD-SETTING ENVIRONMENT How does Best Buy decide on the type of �inancial 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. �inancial 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 �inancial 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 �irms. 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 �inancial reports of South Korean companies were inadequate and inaccurate. Accounting practices there often resulted in huge differences between stated revenues

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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 con�idence 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 signi�icant 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 �irst 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 �inancial reporting is to provide �inancial 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo3#c02-�ig-0018) (page 60)..

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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, veri�iability, 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 veri�iable if independent observers, using the same methods, obtain similar results. As noted in Chapter 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) , certi�ied public accountants (CPAs) perform audits of �inancial 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 in�luence 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 �iscal year. But a �iscal year need not match the calendar year. For example, a company could end its �iscal 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

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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 �inancial 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02lo3#c02-�ig-0019) . These include assumptions about the monetary unit, economic entity, periodicity, and going concern.

ILLUSTRATION 2-19 Key assumptions in �inancial reporting

ETHICS NOTE

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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' �inancial 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 �igures 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 �inancial statement users. If an important item cannot reasonably be reported directly in one of the four types of �inancial statements, then it should be discussed in notes that accompany the statements.

COST CONSTRAINT

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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 bene�it that �inancial statement users will gain from having the information available.

DO IT! 3

Financial Accounting Concepts and Principles

The following items guide the FASB when it creates accounting standards.

Relevance Periodicity assumption Faithful representation Going concern assumption Comparability Historical cost principle Consistency Full disclosure principle Monetary unit assumption Materiality Economic entity assumption

Match each item above with a description below.

1. _______ Ability to easily evaluate one company's results relative to another's.

2. _______ Belief that a company will continue to operate for the foreseeable future.

3. _______ The judgment concerning whether an item is large enough to matter to decision-makers.

4. _______ The reporting of all information that would make a difference to �inancial statement users.

5. _______ The practice of preparing �inancial statements at regular intervals.

6. _______ The quality of information that indicates the information makes a difference in a decision.

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7. _______ A belief that items should be reported on the balance sheet at the price that was paid to acquire the item.

8. _______ A company's use of the same accounting principles and methods from year to year.

9. _______ Tracing accounting events to particular companies.

10. _______ The desire to minimize errors and bias in �inancial statements.

11. _______ Reporting only those things that can be measured in dollars.

Action Plan ✓ Understand the need for conceptual guidelines in accounting.

✓ List the characteristics of useful �inancial information.

✓ Review the assumptions, principles, and constraint that comprise the guidelines in accounting.

SOLUTION

1. Comparability

2. Going concern assumption

3. Materiality

4. Full disclosure principle

5. Periodicity assumption

6. Relevance

7. Historical cost principle

8. Consistency

9. Economic entity assumption

10. Faithful representation

11. Monetary unit assumption

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Related exercise material: BE2-8, BE2-9, BE2-10, DO IT! 2-3, E2-12, and E2-13.

USING DECISION TOOLS—TWEETER HOME ENTERTAINMENT In this chapter, we evaluated a home electronics giant, Best Buy. Tweeter Home Entertainment sold consumer electronics products from 154 stores on the East Coast under various names. It specialized in products with high-end features. Tweeter �iled for bankruptcy in June 2007 and was acquired by another company in July 2007. Financial data for Tweeter, prior to its bankruptcy, are provided below.

September 30 (amounts in millions) 2006 2005 Current assets $146.4  $158.2  Total assets 258.6  284.0  Current liabilities 107.1  119.0  Total liabilities 190.4  201.1  Total common stockholders' equity 68.2  82.9  Net income (loss) (16.5) (74.4) Net cash provided (used) by operating activities 15.6  (26.7) Capital expenditures (net) 17.4  22.2  Dividends paid 0    0    Weighted-average shares of common stock (millions) 25.2  24.6 

INSTRUCTIONS

Using the data provided, answer the following questions and discuss how these results might have provided an indication of Tweeter's �inancial troubles.

1. Calculate the current ratio for Tweeter for 2006 and 2005 and discuss its liquidity position.

2. Calculate the debt to assets ratio and free cash �low for Tweeter for 2006 and 2005 and discuss its solvency.

3. Calculate the earnings per share for Tweeter for 2006 and 2005, and discuss its change in pro�itability.

4. Best Buy's accounting year-end was February 28, 2006; Tweeter's was September 30, 2006. How does this difference affect your ability to compare their pro�itability?

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SOLUTION

1. Current ratio:

2006:$146.4÷$107.1=1.37:12005:$158.2÷$119.0=1.33:1

Tweeter's liquidity improved slightly from 2005 to 2006, but in both years it would most likely have been considered inadequate. In 2006, Tweeter had only $1.37 in current assets for every dollar of current liabilities. Sometimes larger companies, such as Best Buy, can function with lower current ratios because they have alternative sources of working capital. But a company of Tweeter's size would normally want a higher ratio.

2. Debt to assets ratio:

2006:$190.4÷$258.6=73.6%2005:$201.1÷$284.0=70.8%

Tweeter's solvency, as measured by its debt to assets ratio, declined from 2005 to 2006. Its ratio of 73.6% meant that every dollar of assets was �inanced by 73.6 cents of debt. For a retailer, this is extremely high reliance on debt. This low solvency suggests Tweeter's ability to meet its debt payments was questionable.

Free cash �low:

2006:$15.6−$17.4−$0=−$1.8 million2005:−$26.7−$22.2−$0=− $48.9 million

Tweeter's free cash �low was negative in both years. The company did not generate enough net cash provided by operating activities even to cover its capital expenditures, and it was not paying a dividend. While this is not unusual for new companies in their early years, it is also not sustainable for very long. Part of the reason that its debt to assets ratio, discussed above, was so high was that it had to borrow money to make up for its de�icient free cash �low.

3. Loss per share:

2006:−$16.5÷$25.2=−$0.65 per share2005:−$74.4÷$24.6=− $3.02 per share

Tweeter's loss per share declined substantially. However, this was little consolation for its shareholders, who experienced losses in previous years as well. The company's lack of pro�itability, combined with its poor liquidity and solvency, increased the likelihood that it would eventually �ile for bankruptcy.

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4. Tweeter's income statement covers 7 months not covered by Best Buy's. Suppose that the economy changed dramatically during this 7-month period, either improving or declining. This change in the economy would be re�lected in Tweeter's income statement but would not be re�lected in Best Buy's income statement until the following March, thus reducing the usefulness of a comparison of the income statements of the two companies.

REVIEW AND PRACTICE

LEARNING OBJECTIVES REVIEW 1. Identify the sections of a classi�ied balance sheet. In a classi�ied balance sheet,

companies classify assets as current assets; long-term investments; property, plant, and equipment; and intangibles. They classify liabilities as either current or long-term. A stockholders' equity section shows common stock and retained earnings.

2. Use ratios to evaluate a company's pro�itability, liquidity, and solvency. Ratio analysis expresses the relationship among selected items of �inancial statement data. Pro�itability ratios, such as earnings per share (EPS), measure aspects of the operating success of a company for a given period of time.

Liquidity ratios, such as the current ratio, measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. Solvency ratios, such as the debt to assets ratio, measure the ability of a company to survive over a long period. Free cash �low indicates a company's ability to generate net cash provided by operating activities that is suf�icient to pay debts, acquire assets, and distribute dividends.

3. Discuss �inancial reporting concepts. Generally accepted accounting principles are a set of rules and practices recognized as a general guide for �inancial reporting purposes. The basic objective of �inancial reporting is to provide information that is useful for decision-making.

To be judged useful, information should have the primary characteristics of relevance and faithful representation. In addition, useful information is comparable, consistent, veri�iable, timely, and understandable.

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The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption states that economic events can be identi�ied with a particular unit of accountability. The periodicity assumption states that the economic life of a business can be divided into arti�icial time periods and that meaningful accounting reports can be prepared for each period. The going concern assumption states that the company will continue in operation long enough to carry out its existing objectives and commitments.

The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The full disclosure principle requires that companies disclose circumstances and events that matter to �inancial statement users.

The cost constraint weighs the cost that companies incur to provide a type of information against its bene�it to �inancial statement users.

DECISION TOOLS REVIEW

GLOSSARY REVIEW Classi�ied balance sheet A balance sheet that groups together similar assets and similar

liabilities, using a number of standard classi�ications and sections.

Comparability Ability to compare the accounting information of different companies because they use the same accounting principles.

Consistency Use of the same accounting principles and methods from year to year within a company.

Cost constraint Constraint that weighs the cost that companies will incur to provide the information against the bene�it that �inancial statement users will gain from having the information available.

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Current assets Assets that companies expect to convert to cash or use up within one year or the operating cycle, whichever is longer.

Current liabilities Obligations that a company expects to pay within the next year or operating cycle, whichever is longer.

Current ratio A measure of liquidity computed as current assets divided by current liabilities.

Debt to assets ratio A measure of solvency calculated as total liabilities divided by total assets. It measures the percentage of total �inancing provided by creditors.

Earnings per share (EPS) A measure of the net income earned on each share of common stock; computed as net income minus preferred dividends divided by the weighted- average number of common shares outstanding during the year.

Economic entity assumption An assumption that every economic entity can be separately identi�ied and accounted for.

Fair value principle Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

Faithful representation Information that is complete, neutral, and free from error.

Financial Accounting Standards Board (FASB) The primary accounting standard- setting body in the United States.

Free cash �low Net cash provided by operating activities after adjusting for capital expenditures and cash dividends paid.

Full disclosure principle Accounting principle that dictates that companies disclose circumstances and events that make a difference to �inancial statement users.

Generally accepted accounting principles (GAAP) A set of accounting standards that have substantial authoritative support and which guide accounting professionals.

Going concern assumption The assumption that the company will continue in operation for the foreseeable future.

Historical cost principle An accounting principle that states that companies should record assets at their cost.

Intangible assets Assets that do not have physical substance.

International Accounting Standards Board (IASB) An accounting standard-setting body that issues standards adopted by many countries outside of the United States.

International Financial Reporting Standards (IFRS) Accounting standards, issued by the IASB, that have been adopted by many countries outside of the United States.

Liquidity The ability of a company to pay obligations that are expected to become due within the next year or operating cycle.

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Liquidity ratios Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

Long-term investments Generally, (1) investments in stocks and bonds of other corporations that companies hold for more than one year; (2) long-term assets, such as land and buildings, not currently being used in the company's operations; and (3) long- term notes receivable.

Long-term liabilities Obligations that a company expects to pay after one year.

Materiality Whether an item is large enough to likely in�luence the decision of an investor or creditor.

Monetary unit assumption An assumption that requires that only those things that can be expressed in money are included in the accounting records.

Operating cycle The average time required to purchase inventory, sell it on account, and then collect cash from customers—that is, go from cash to cash.

Periodicity assumption An assumption that the life of a business can be divided into arti�icial time periods and that useful reports covering those periods can be prepared for the business.

Pro�itability ratios Measures of the operating success of a company for a given period of time.

Property, plant, and equipment Assets with relatively long useful lives that are currently used in operating the business.

Public Company Accounting Oversight Board (PCAOB) The group charged with determining auditing standards and reviewing the performance of auditing �irms.

Ratio analysis A technique that expresses the relationship among selected items of �inancial statement data.

Ratio An expression of the mathematical relationship between one quantity and another.

Relevance The quality of information that indicates the information makes a difference in a decision.

Securities and Exchange Commission (SEC) The agency of the U.S. government that oversees U.S. �inancial markets and accounting standard-setting bodies.

Solvency ratios Measures of the ability of the company to survive over a long period of time.

Solvency The ability of a company to pay interest as it comes due and to repay the balance of debt due at its maturity.

Timely Information that is available to decision-makers before it loses its capacity to in�luence decisions.

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Understandability Information presented in a clear and concise fashion so that users can interpret it and comprehend its meaning.

Veri�iable The quality of information that occurs when independent observers, using the same methods, obtain similar results.

Working capital The difference between the amounts of current assets and current liabilities.

PRACTICE MULTIPLE-CHOICE QUESTIONS (LO 1)

1. In a classi�ied balance sheet, assets are usually classi�ied as:

(a) current assets; long-term assets; property, plant, and equipment; and intangible assets.

(b) current assets; long-term investments; property, plant, and equipment; and common stock.

(c) current assets; long-term investments; tangible assets; and intangible assets.

(d) current assets; long-term investments; property, plant, and equipment; and intangible assets.

(LO 1)

2. Current assets are listed:

(a) by order of expected conversion to cash.

(b) by importance.

(c) by longevity.

(d) alphabetically.

(LO 1)

3. The correct order of presentation in a classi�ied balance sheet for the following current assets is:

(a) accounts receivable, cash, prepaid insurance, inventory.

(b) cash, inventory, accounts receivable, prepaid insurance.

(c) cash, accounts receivable, inventory, prepaid insurance.

(d) inventory, cash, accounts receivable, prepaid insurance.

(LO 1)

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4. A company has purchased a tract of land. It expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. The land should be reported as:

(a) property, plant, and equipment.

(b) land expense.

(c) a long-term investment.

(d) an intangible asset.

(LO 1)

5. The balance in retained earnings is not affected by:

(a) net income.

(b) net loss.

(c) issuance of common stock.

(d) dividends.

(LO 2)

6. Which is an indicator of pro�itability?

(a) Current ratio.

(b) Earnings per share.

(c) Debt to assets ratio.

(d) Free cash �low.

(LO 2)

7. For 2017, Spanos Corporation reported net income $26,000, net sales $400,000, and weighted-average shares outstanding 4,000. There were preferred dividends of $2,000. What was the 2017 earnings per share?

(a) $6.00.

(b) $6.50.

(c) $99.50.

(d) $100.00.

(LO 2)

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8. Which of these measures is an evaluation of a company's ability to pay current liabilities?

(a) Earnings per share.

(b) Current ratio.

(c) Both (a) and (b).

(d) None of the above.

(LO 2)

9. The following ratios are available for Reilly Inc. and O'Hare Inc.

Current Ratio

Debt to Assets Ratio

Earnings per Share

Reilly Inc. 2:1 75% $3.50

O'Hare Inc. 1.5:1 40% $2.75

Compared to O'Hare Inc., Reilly Inc. has:

(a) higher liquidity, higher solvency, and higher pro�itability.

(b) lower liquidity, higher solvency, and higher pro�itability.

(c) higher liquidity, lower solvency, and higher pro�itability.

(d) higher liquidity and lower solvency, but pro�itability cannot be compared based on information provided.

(LO 2)

10. Companies can use free cash �low to:

(a) pay additional dividends.

(b) acquire property, plant, and equipment.

(c) pay off debts.

(d) All of the above.

(LO 3)

11. Generally accepted accounting principles are:

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(a) a set of standards and rules that are recognized as a general guide for �inancial reporting.

(b) usually established by the Internal Revenue Service.

(c) the guidelines used to resolve ethical dilemmas.

(d) fundamental truths that can be derived from the laws of nature.

(LO 3)

12. What organization issues U.S. accounting standards?

(a) Financial Accounting Standards Board.

(b) International Accounting Standards Committee.

(c) International Auditing Standards Committee.

(d) None of the above.

(LO 3)

13. What is the primary criterion by which accounting information can be judged?

(a) Consistency.

(b) Predictive value.

(c) Usefulness for decision-making.

(d) Comparability.

(LO 3)

14. Neutrality is an ingredient of:

Faithful Representation Relevance (a) Yes Yes (b) No No (c) Yes No (d) No Yes

(LO 3)

15. The characteristic of information that evaluates whether it is large enough to impact a decision.

(a) Comparability.

(b) Materiality.