A short recap on last periods topics
FM1 focused on adding financial information to a financial information system
FM2 centres around financial analysis and capital investment analysis by introducing
long-term (=capital) budgeting.
Assets resources
Liabilities obligations
Revenues income
Expenses costs
Withdrawals money from company to owners
Investments money from owners to company
Income statement statement of owner’s equity
Revenues Beginning capital
Expenses - Investment
NET income 1 NET income 1 +
Sub total
Withdrawals -
Ending capital
Balance sheet Cash flow statement
Assets Liabilities
This one we will learn this period
Owner’s equity
A = L + OE
,Chapter 5 – Foundations of Financial
Reporting and the classified balance sheet
Financial reporting
Profitability and liquidity are important measures for investors and creditors; financial
statements support these decision makers and should enable these users to do the
following:
1. asses cash flow prospects
2. assess stewardship
Aside from financial statements, financial reporting also involves other information such
as management’s explanations, assumptions, uncertainties and estimates.
Qualitative characteristics of accounting information:
1. Relevance
2. Faithful representation
3. Comparability
4. Verifiability
5. Timeliness
6. Understand ability
Familiarity with the accounting conventions enables the user to better understand
accounting information. Among these accounting conventions are:
- Consistency requires that once a company has adopted an accounting
procedure, it must use if from one period to the next
- Full disclosure requires that financial statements present all the information
relevant to users’ understanding
- Materiality refers to the relative importance of an item or event.
Conservatism applies when accountants have to choose between two equally
acceptable procedures: they should choose the one that is least likely to overstate assets
an income.
Cost-benefit holds that benefits to be gained from providing accounting information
should be greater than the cost of this information.
Under the Sarbanes-Oxley act, chief executive officers and chief financial officers of al
publicly traded companies must certify that, to their knowledge, their quarterly and
annual statements are accurate and complete.
Fraudulent financial reporting can have high costs for investors, lenders, employees and
customers as well as for the people who condone authorize or prepare misleading reports.
,Classified balance sheet
Classified financial statements – external
financial statements divided into subcategories.
Reality does not change; numbers are only
represented differently.
Assets are divided into 4 categories. These are
listed in the order of how easily they can be
converted to cash.
- Current assets – include cash and other
assets that a company can reasonably
expect to convert to cash, sell or consumer
within one year of its normal operating
cycle, whichever is longer.
o A company’s normal operating
cycle is the average time it needs to
go from spending to receiving cash.
- Investments include assets, usually long-
term, that are not used in normal business
operations and that management does not
plan to convert to cash within the next year
- Property, plant and equipment include tangible long-term assets used in a
business’s day-to-day operations. (fixed assets)
- Intangible assets are long-term assets with no physical substance. Their value
stems from the right or privileges accruing to their owners
Liabilities are divided into 2 categories:
- Current liabilities – obligations that must be satisfied within one year or within
the company’s normal operating cycle, whichever is longer (notes payable,
accounts payable, salaries etc.)
- Long-term liabilities – debts that fall due more than one year in the future or
beyond the normal operating cycle (long-term notes, mortgages payable,
employee pension obligations)
Owner’s equity is the owner’s interest in a company. The equity section of the balance
sheet differs depending on whether the business is a sole proprietorship, a partnership of
a corporation:
- Sole proprietorship – this owner’s equity would just be the capital of the owner
in the company
- Partnership – the equity section of a partnership’s balance sheet is called
partner’s equity. It is both owner’s capital added up.
- Corporation – the equity section of a balance sheet for a corporation is called
stockholders’ equity. It has two parts:
o Contributed capital (paid-in capital) – reflects the amount of assets
invested by stockholders.
, o Retained earnings (earned capital) – represents the stockholders’ claim
to the assets that are earned from operations and reinvested in corporate
operations.
Dividends distributions of assets to shareholders.
Multi-step income statement
This income statement goes through a series of
steps to arrive at net income. It is for a service
company (which buys and sells products) than a
manufacturing company (which
makes and sells products).
NET sales = Gross sales – sales returns and allowances.
Gross sales – the total revenue from cash and credit sales during a period
Sales returns and allowances – cash refunds and credits on account. (also include
discounts).
Cost of goods sold is the amount a merchandiser paid for the merchandise it sold
during a period.
Gross margin = NET sales – cost of goods sold
Managers are interested in both the amount and percentage of gross margin
% gross margin = gross margin / NET sales
operating expenses are the expenses, other than the cost of goods sold, that are
incurred in running a business. They are often grouped into the categories of selling
expenses and general and administrative expenses.
Operating expenses = selling expenses + general and administrative expenses
Selling expenses – include the costs of storing goods and preparing them for sale;
preparing displays, advertising and otherwise promoting sales; and delivering goods to
buyers if the seller has agreed to pay the cost of delivery
General and administrative expenses – include expenses for accounting, personnel,
credit checking, collections and any other expenses that apply to overall operations.
, Operating income is the income from a company’s main business.
Operating income – gross margin – operating expenses.
Other revenues and expenses are not related to a company’s operating activities.
(revenues from investment; dividends and interest on stocks, bonds, and savings
account; interest expense and other expenses that result from borrowing money.)
NET income Gross margin – operating expenses +/- other revenues and expenses
Taxes: - interest earned: + interest paid: -
Ratio’s
Ratio’s use the components of classified financial statements to reflect how well a firm
has performed in term of maintaining liquidity and achieving profitability.
Liquidity
Working capital: the amount by which current assets exceed current liabilities
Working capital = current assets - current liabilities
Current ratio: ratio of current assets to current liabilities
Current ratio = current assets / current liabilities
Liquidity means having enough money on hand to pay bills when they are due and to
take care of unexpected needs for cash.
To determine whether a current ratio is good or bad, it must be compared with ratios for
earlier years and with similar measures for companies in the same industry.
Profitability
Profit margin: percentage of each sales dollar that results in NET income
Profit margin = NET income / NET sales
Asset turnover: ratio of sales dollars to assets
Asset turnover = NET sales / average total assets (av. Tot. assets = assets
beginning + assets ending / 2)
Return on assets: percentage of each dollar in assets resulting in NET income, thereby
combining the profit margin and the asset turnover
Return on assets = NET income / average total assets
Return on assets = profit margin X asset turnover
Debt to equity ratio: proportion of a company’s assets that is financed by creditors to
the proportion that is financed by the owner
Debt to equity ratio = total liabilities / owner’s equity
Return on equity: percentage of each dollar in owner’s equity resulting in NET income
Return on equity = NET income / average owner’s equity (av. OE = OE beginning +
OE ending / 2)
Profitability is the ability to earn a satisfactory income.
A company with a high asset turnover uses its assets more productively than one with a
low asset turnover.
FM1 focused on adding financial information to a financial information system
FM2 centres around financial analysis and capital investment analysis by introducing
long-term (=capital) budgeting.
Assets resources
Liabilities obligations
Revenues income
Expenses costs
Withdrawals money from company to owners
Investments money from owners to company
Income statement statement of owner’s equity
Revenues Beginning capital
Expenses - Investment
NET income 1 NET income 1 +
Sub total
Withdrawals -
Ending capital
Balance sheet Cash flow statement
Assets Liabilities
This one we will learn this period
Owner’s equity
A = L + OE
,Chapter 5 – Foundations of Financial
Reporting and the classified balance sheet
Financial reporting
Profitability and liquidity are important measures for investors and creditors; financial
statements support these decision makers and should enable these users to do the
following:
1. asses cash flow prospects
2. assess stewardship
Aside from financial statements, financial reporting also involves other information such
as management’s explanations, assumptions, uncertainties and estimates.
Qualitative characteristics of accounting information:
1. Relevance
2. Faithful representation
3. Comparability
4. Verifiability
5. Timeliness
6. Understand ability
Familiarity with the accounting conventions enables the user to better understand
accounting information. Among these accounting conventions are:
- Consistency requires that once a company has adopted an accounting
procedure, it must use if from one period to the next
- Full disclosure requires that financial statements present all the information
relevant to users’ understanding
- Materiality refers to the relative importance of an item or event.
Conservatism applies when accountants have to choose between two equally
acceptable procedures: they should choose the one that is least likely to overstate assets
an income.
Cost-benefit holds that benefits to be gained from providing accounting information
should be greater than the cost of this information.
Under the Sarbanes-Oxley act, chief executive officers and chief financial officers of al
publicly traded companies must certify that, to their knowledge, their quarterly and
annual statements are accurate and complete.
Fraudulent financial reporting can have high costs for investors, lenders, employees and
customers as well as for the people who condone authorize or prepare misleading reports.
,Classified balance sheet
Classified financial statements – external
financial statements divided into subcategories.
Reality does not change; numbers are only
represented differently.
Assets are divided into 4 categories. These are
listed in the order of how easily they can be
converted to cash.
- Current assets – include cash and other
assets that a company can reasonably
expect to convert to cash, sell or consumer
within one year of its normal operating
cycle, whichever is longer.
o A company’s normal operating
cycle is the average time it needs to
go from spending to receiving cash.
- Investments include assets, usually long-
term, that are not used in normal business
operations and that management does not
plan to convert to cash within the next year
- Property, plant and equipment include tangible long-term assets used in a
business’s day-to-day operations. (fixed assets)
- Intangible assets are long-term assets with no physical substance. Their value
stems from the right or privileges accruing to their owners
Liabilities are divided into 2 categories:
- Current liabilities – obligations that must be satisfied within one year or within
the company’s normal operating cycle, whichever is longer (notes payable,
accounts payable, salaries etc.)
- Long-term liabilities – debts that fall due more than one year in the future or
beyond the normal operating cycle (long-term notes, mortgages payable,
employee pension obligations)
Owner’s equity is the owner’s interest in a company. The equity section of the balance
sheet differs depending on whether the business is a sole proprietorship, a partnership of
a corporation:
- Sole proprietorship – this owner’s equity would just be the capital of the owner
in the company
- Partnership – the equity section of a partnership’s balance sheet is called
partner’s equity. It is both owner’s capital added up.
- Corporation – the equity section of a balance sheet for a corporation is called
stockholders’ equity. It has two parts:
o Contributed capital (paid-in capital) – reflects the amount of assets
invested by stockholders.
, o Retained earnings (earned capital) – represents the stockholders’ claim
to the assets that are earned from operations and reinvested in corporate
operations.
Dividends distributions of assets to shareholders.
Multi-step income statement
This income statement goes through a series of
steps to arrive at net income. It is for a service
company (which buys and sells products) than a
manufacturing company (which
makes and sells products).
NET sales = Gross sales – sales returns and allowances.
Gross sales – the total revenue from cash and credit sales during a period
Sales returns and allowances – cash refunds and credits on account. (also include
discounts).
Cost of goods sold is the amount a merchandiser paid for the merchandise it sold
during a period.
Gross margin = NET sales – cost of goods sold
Managers are interested in both the amount and percentage of gross margin
% gross margin = gross margin / NET sales
operating expenses are the expenses, other than the cost of goods sold, that are
incurred in running a business. They are often grouped into the categories of selling
expenses and general and administrative expenses.
Operating expenses = selling expenses + general and administrative expenses
Selling expenses – include the costs of storing goods and preparing them for sale;
preparing displays, advertising and otherwise promoting sales; and delivering goods to
buyers if the seller has agreed to pay the cost of delivery
General and administrative expenses – include expenses for accounting, personnel,
credit checking, collections and any other expenses that apply to overall operations.
, Operating income is the income from a company’s main business.
Operating income – gross margin – operating expenses.
Other revenues and expenses are not related to a company’s operating activities.
(revenues from investment; dividends and interest on stocks, bonds, and savings
account; interest expense and other expenses that result from borrowing money.)
NET income Gross margin – operating expenses +/- other revenues and expenses
Taxes: - interest earned: + interest paid: -
Ratio’s
Ratio’s use the components of classified financial statements to reflect how well a firm
has performed in term of maintaining liquidity and achieving profitability.
Liquidity
Working capital: the amount by which current assets exceed current liabilities
Working capital = current assets - current liabilities
Current ratio: ratio of current assets to current liabilities
Current ratio = current assets / current liabilities
Liquidity means having enough money on hand to pay bills when they are due and to
take care of unexpected needs for cash.
To determine whether a current ratio is good or bad, it must be compared with ratios for
earlier years and with similar measures for companies in the same industry.
Profitability
Profit margin: percentage of each sales dollar that results in NET income
Profit margin = NET income / NET sales
Asset turnover: ratio of sales dollars to assets
Asset turnover = NET sales / average total assets (av. Tot. assets = assets
beginning + assets ending / 2)
Return on assets: percentage of each dollar in assets resulting in NET income, thereby
combining the profit margin and the asset turnover
Return on assets = NET income / average total assets
Return on assets = profit margin X asset turnover
Debt to equity ratio: proportion of a company’s assets that is financed by creditors to
the proportion that is financed by the owner
Debt to equity ratio = total liabilities / owner’s equity
Return on equity: percentage of each dollar in owner’s equity resulting in NET income
Return on equity = NET income / average owner’s equity (av. OE = OE beginning +
OE ending / 2)
Profitability is the ability to earn a satisfactory income.
A company with a high asset turnover uses its assets more productively than one with a
low asset turnover.
