Chapter 2: Financial Statements and the Annual Report

1. Chapter 2:Financial Statements andthe Annual Report

2. Objectives of Financial Reporting Primary Objective of Financial Reporting: -to provide economic information to the users of financial statements, to permit the users to make informed decisions. Secondary Objectives: -to reflect prospective cash flows to investors and creditors. -to reflect prospective cash flows to the company. -to reflect company resources and claims to the resources.

3. Qualitative Characteristics of Financial Reporting Understandability - comprehensible to those willing to spend the time to study the financials. Relevance - the capacity of information to make a difference in a decision. Reliability - verifiable information that represents what it purports to represents. Comparability - ability to compare financials of different firms. Consistency - ability to compare financials of a particular firm from year to year.

4. Qualitative Characteristics of Financial Reporting Limitations on Qualitative Characteristics: Materiality (immateriality) constraint - if a transaction is immaterial, it need not follow GAAP. Conservatism - for certain valuations, where two alternative values are available, the company should use the least optimistic value (lower assets, lower revenues, higher liabilities, higher expenses).

5. Multiple Step I/S For the year ended December 31, 2008 Sales $357,500 Cost of Goods Sold 218,300 Gross Profit $139,200 Operating expenses: Selling expenses Depreciation on store furniture and fixtures $ 4,000 Advertising 13,750 Salaries and wages 22,000 Total selling expenses $ 39,950 General and administrative expenses Depreciation of buildings and amortization of trademark $ 6,000 Salaries and wages 15,000 Insurance 3,600 Supplies 1,050 Total general and administrative expenses 25,650 Income from operations $ 73,600 Other revenues and expenses: Interest revenue $ 1,500 Interest expense 16,900 Excess of other revenues over other expenses 15,400 Income before taxes $ 58,200 Income tax expense 17,200 Net income $ 41,000

6. Statement of Retained Earnings For the year ended December 31, 2008 Retained earnings, January 1, 2008 $271,500 Add: net income, 2008 41,000 Less: dividends declared in 2008 (25,000) Retained earnings, December 31, 2008 $ 287,500 Note that ending retained earnings is carried to the balance sheet, in the stockholders’ section. Now work Exercise 2-9.

7. Classified B/S At December 31, 2008 ASSETS Current assets Cash $ 5,000 Marketable securities 11,000 Accounts receivable 23,000 Merchandise inventory 73,500 Prepaid insurance 4,800 Supplies 700 Total current assets $118,000 Investments Land held for future expansion 150,000 Property, plant, and equipment Land $100,000 Buildings $150,000 Less: Accumulated depreciation (60,000) 90,000 Store furniture and fixtures $ 42,000 Less: Accumulated depreciation (12,600) 29,400 Total property, plant and equipment 219,400 Intangible assets Franchise agreement 55,000 Total assets$542,400

8. Classified B/S At December 31, 2008 LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities Accounts payable $ 15,700 Salaries and wages payable 9,500 Income taxes payable 7,200 Interest payable 2,500 Bank loan payable 25,000 Total current liabilities $ 59,900 Long-term debt Notes payable $ 120,000 Total liabilities $ 179,900 Contributed capital Capital stock, $10 par, 5,000 shares issued and outstanding$ 50,000 Paid-in capital in excess of par value 25,000 Total contributed capital $ 75,000 Retained earnings 287,500 Total stockholders' equity $ 362,500 Total liabilities and stockholders’ equity $ 542,400

9. Classification of Current Assets Current assets are assets that will be converted to cash, or used up, within the next 12 months or operating cycle, whichever is longer. Most companies have an operating cycle (next page) less than a year, but a few industries might have an operating cycle longer than a year. For those industries, the classification of current assets would be based on the length of the operating cycle. Examples of industries that could have long operating cycles include aerospace, farm equipment, shipbuilding, and other companies with long manufacturing or sales cycles.

10. The Operating Cycle Cash Receive payment Manufacture or purchase inventory Accounts Receivable Inventory Sales to customers Note that the operating cycle is effectively complete when the cash is “collectible,” or at the A/R stage.

11. Current Ratios Working Capital = Current Assets - Current Liabilities Current Ratio = Current Assets/Current Liabilities Indicate liquidity of a firm - the ability to meet its current obligations. Now work Problem 2-3.

12. Annual Reports Large companies file annual, audited reports with their shareholders. The reports contain the financial statements and notes to the financial statements. Example: Kellogg’s (Appendix B)

13. Exercise 2-9 2008: RE 1/1 $ 0 Add NI 85,200 Less: Dividends (40,000) RE 12/31 $45,200 2009: RE 1/1 $ 45,200 Add NI 125,320 Less: Dividends (40,000) RE 12/31 $ 130,520 2010: RE 1/1 $130,520 Add NI 145,480 Less: Dividends (40,000) RE 12/31 $236,000 Back to class notes.

14. Problem 2-3 1. First, classify items as to location in B/S, then create B/S: A/P: CL A/R: CA A/D –Autos: PPE (contra) A/D-Bldgs: PPE (contra) Auto: PPE B/P: LTL Bldg: PPE CS: SE Cash: CA IT Pay: CL Int. Pay: CL Inven.: CA

15. Problem 2-3 Land: PPE LTI: Invest. NP: CL Off. Supp.: CA Paid in Capital: SE Patents: Intangible PP Rent: CA RE: SE Sal. Pay: CL (Use format similar to page 64 to create B/S) • Calculate CA & CL (or get from B/S in part 1): CA: 23,450+13,230+45,730+2,340+1,500 = $86,250 CL: 18,255+6,200+1,500+10,000+4,200 = $40,155 Current ratio = CA/CL = 2.15 (or 2.15 to 1) Back to Class Notes.