How To Read and Interpret Financial Statements

How to Read and Interpret
Financial Statements
Second Edition
A Guide to Understanding What the

Numbers Really Mean
This page intentionally left blank
How to Read and Interpret
Financial Statements
Second Edition
A Guide to Understanding What the

Numbers Really Mean
Michael P. Griffin
How to Read and Interpret Financial Statements, Second Edition
A Guide to Understanding What the Numbers Really Mean
© 2015 American Management Association. All rights reserved. This material may not be reproduced, stored in a retrieval system,
or transmitted in whole or in part, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise,
without the prior written permission of the publisher.
ISBN 10: 0-7612-1559-X
ISBN 13: 978-0-7612-1559-2
AMACOM Self-Study Program
http://www.amaselfstudy.org
AMERICAN MANAGEMENT ASSOCIATION
http://www.amanet.org
Contents
About This Course ix
How to Take This Course xi
Pre-Test xiii
1 Understanding Financial Statements 1

Introduction
Accounting Is More an Art Than a Science
Internal Users
External Users
Basic Concepts and Principles of Financial Accounting and Financial
Statements
Generally Accepted Accounting Principles (GAAP)
Auditor’s Reports
Limitations of Financial Statements
Recap
Review Questions
Answers to “Think About It…” Questions from This Chapter
2 Types of Financial Statements 19

Introduction
Elements of Financial Statements
Assets
Liabilities
Equity
Investments by Owners
Distributions to Owners
Revenues
Expenses
Gains
Losses
The Balance Sheet
Assets
Liabilities
Owners’ Equity
Income Statement
Sales
v
© American Management Association. All rights reserved.
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vi HOW TO READ AND INTERPRET FINANCIAL STATEMENTS
Cost of Goods Sold

Statement of Retained Earnings
Statement of Cash Flows
Notes to the Financial Statements and Supplemental Information
Management’s Discussion and Analysis of Financial Condition and
Results of Operation
Recap
Review Questions
3 The Balance Sheet: Assets 41

Introduction
Current Assets
Cash
Marketable Securities
Receivables
Inventories
Prepaid Expenses
Long-Term Investments
Cost Method of Valuation
Equity Method of Valuation
Property, Plant, and Equipment
Tangible Fixed Assets
Intangible Assets
Wasting Assets
Other Assets
Recap
Review Questions
4 The Balance Sheet: Liabilities and 57

Owners’ Equity
Introduction
Liabilities
Current Liabilities
Long-Term Liabilities
Off-Balance-Sheet Financing
Owners’ (or Shareholders’) Equity
Capital Stock
Additional Paid-In Capital
Retained Earnings
Treasury Stock
Recap
Review Questions

CONTENTS vii
5 The Income Statement 71

Introduction
Income Statement Format
Components of an Income Statement
Comprehensive Income
Cash Versus Accrual Basis of Accounting
Cash Basis
Accrual Basis
Apportionment of Revenues and Expenses
Prepaid Expenses Requiring Apportionment
Unearned and Recorded Revenues Requiring Apportionment
Unrecorded Accrued Revenues
Unrecorded Accrued Expenses
Valuation of Accounts Receivable and Investments
Valuation of Marketable Securities
Recap
Review Questions
6 The Statement of Cash Flows 83

Introduction
The Usefulness of the Statement of Cash Flows
The Nature of the Statement of Cash Flows
Significant Noncash Financing and Investing Activities
Statement of Cash Flows: Format Alternatives
The Direct Method
The Indirect Method
Free Cash Flow
Recap
Review Questions
7 Balance Sheet Analysis 93

Introduction
Ratios in Financial-Statement Analysis
Limitations of Financial Ratios
Categories of Financial Ratios
Liquidity Ratios
Activity Ratios
Leverage Ratios
Vertical and Horizontal Analysis
Recap
Review Questions
8 Income Statement Analysis 111

Sales
viii HOW TO READ AND INTERPRET FINANCIAL STATEMENTS
Cost of Goods Sold

Gross Profit
Operating Expenses
Operating Income
Profitability Ratios
Gross Profit Margin
Operating Profit Margin
Profit Margin
Return on Assets
Return on Equity
Earnings Per Share
Horizontal and Vertical Analysis
Recap
Review Questions
9 Analysis of Operational Results 123

Introduction
Cost Behavior
Fixed Costs
Variable Costs
Mixed Costs
Cost-Volume-Profit Analysis
Break-Even Point
The Graphic Presentation of Break-Even
Using Break-Even Analysis
Contribution Margin
Advantages of Cost-Volume-Profit Analysis
Limitations of Cost-Volume-Profit Analysis
The Profit-Volume Graph
Plotting a Profit Line
Recap
Review Questions
Bibliography 137
Glossary 139
Online Resources 147
Post-Test 149
Index 155
FOR QUESTIONS AND COMMENTS:

Please contact Self Study at 1-800-225-3215 or email
AMASelfStudy@amanet.org for information about
Self Study courses. And visit our website at www.amaselfstudy.org

About This Course
The ability to read and interpret financial statements is a critical skill for any
manager. How to Read and Interpret Financial Statements, Second Edition, teaches
readers to read, understand, and analyze the financial reports that are funda-
mental to understanding the overall health of a business. Readers will learn to
interpret balance sheets, income statements, and statements of cash flows from
a management perspective. They’ll gain insights into how to view financial
statements in the context of external economic conditions. Readers will learn
how to uncover critical information by applying the right type of analysis—
ratio, vertical, horizontal—to the right statement. Written for today’s practi-
tioner, How to Read and Interpret Financial Statements, Second Edition, highlights
new legislation, rules, and standards of practice that affect accounting and fi-
nance and thereby the interpretation of financial statements. In each chapter,
exhibits, examples, and exercises reinforce the learning and give readers the
chance to apply new concepts and practice new skills.
Michael P. Griffin is an instructor of accounting and finance at the
Charlton College of Business at the University of Massachusetts Dartmouth.
Mr. Griffin received his B.S. in business administration from Providence Col-
lege and an M.B.A. from Bryant College. He is a Certified Public Accountant,
a Certified Management Accountant, a Certified Financial Manager (Institute
of Management Accountants), and a Chartered Financial Consultant (Amer-
ican College). In addition to his teaching experience, Mr. Griffin has held a
variety of positions in the areas of auditing, accounting, and finance and is an
active consultant. He is the author of many books and articles on accounting
and finance topics, including MBA Fundamentals: Accounting and Finance, pub-
lished by Kaplan Publishing. He has also been a content developer for finance
and accounting learning systems (software) for publishers such as McGraw-
Hill and Pearson Education. In addition to his teaching responsibilities at the
Charlton College of Business, Professor Griffin has held the position of As-
sistant Dean and is currently the internship director.
ix
How to Take This Course
This course consists of text material for you to read and three types of activ-
ities (the Pre- and Post-Test, in-text exercises, and end-of-chapter Review
Questions) for you to complete. These activities are designed to reinforce the
concepts brought out in the text portion of the course and to enable you to
evaluate your progress.
Pre- and Post-Tests

Both a pre-test and a post-test are included in this course. Take the pre-test
before you study any of the course material to determine your existing knowl-
edge of the subject matter. To get instructions on taking the test and having
it graded, please email AMASelfStudy@amanet.org, and you will receive an
email back with details on taking your test and getting your grade. This email
will also include instructions on taking your post-test, which you should do
upon completion of the course material.
Certificate
Once you have taken your post-test, you will receive an email with your grade
and a certificate if you have passed the course successfully (70% or higher).
All tests are reviewed thoroughly by our instructors, and your grade and a
certificate will be returned to you promptly.
The Text
The most important component of this course is the text, for it is here that
the concepts and methods are first presented. Reading each chapter twice will
increase the likelihood of your understanding the text fully.
We recommend that you work on this course in a systematic way. Only
by reading the text and working through the exercises at a regular and steady
pace will you get the most out of this course and retain what you have learned.
xi
xii HOW TO READ AND INTERPRET FINANCIAL STATEMENTS
In your first reading, concentrate on getting an overview of the chapter’s con-

tents. Read the learning objectives at the beginning of each chapter first. They
serve as guidelines to the major topics of the chapter and enumerate the skills
you should master as you study the text. As you read the chapter, pay attention
to the heading and subheadings. Find the general theme of the section and
see how that theme relates to others. Don’t let yourself get bogged down with
details during the first reading; simply concentrate on remembering and un-
derstanding the major themes.
In your second reading, look for the details that underlie the themes.
Read the entire chapter carefully and methodically, underlining key points,
working out the details of the examples, and making marginal notations as
you go. Complete the exercises.
Exercises and Activities

Interspersed with the text in each chapter you will find exercises that take a
variety of forms. In some cases, no specific or formal answers are provided.
Where appropriate, suggested responses or commentary follow the exercises.
The Review Questions

After reading a chapter and before going on to the next, work through the re-
view questions. By answering the questions and comparing your own answers
to the answers provided, you will find it easier to grasp the major ideas of that
chapter. If you perform these self-check exercises conscientiously, you will
develop a framework in which to place material presented in later chapters.
Questions About Grading/Retaking the Test

If you have questions regarding the tests, the grading, or the courses itself,
please email Self Study at AMASelfStudy@amanet.org .
If you fail the Post-Test, you have one year to retake the test for one year
after the course’s purchase date.

Pre-Test
How to Read and Interpret Financial Statements

Second Edition
Course Code 98002
INSTRUCTIONS: To take this test and have it graded, please email AMASelfStudy
@amanet.org. You will receive an email back with details on taking your test and get-
ting your grade.
FOR QUESTIONS AND COMMENTS: You can also contact Self Study at 1-800-225-3215
or visit the website at www.amaselfstudy.org.
1. Costs that do not change within a workable range of activity are:

(a) variable.
(b) mixed.
(c) fixed.
(d) direct.
2. Based on the following facts, what is the break-even point?

A company has a fixed cost of $28,000 and a variable cost
per unit of $30. The unit’s selling price is $100.
(a) 300 units
(b) 200 units
(c) 400 units
(d) 500 units
xiii
xiv HOW TO READ AND INTERPRET FINANCIAL STATEMENTS
3. Based on the following facts, how many units must be sold to earn a
profit of $700? A company has a fixed cost of $28,000 and a variable
cost per unit of $30. The unit’s selling price is $100.
(a) 410 units
(b) 401 units
(c) 400 units
(d) 470 units
4. Which of the following ratios is calculated by dividing current assets by

current liabilities?
(a) Quick
(b) Current
(c) Time interest earned
(d) None of the above
5. Which of the following ratios gives the most conservative indication of

liquidity?
(a) Quick
(b) Current
6. Which of the following categories of ratios answers the question:

How well does the company manage its resources?
(a) Liquidity
(b) Activity
(c) Profitability
(d) Leverage
7. What does the following formula measure?

Cost of Beginning Inventory + Net Purchases − Cost of Ending Inventory
(a) Cost of goods sold
(b) Gross margin
(c) Cost of goods available for sale
(d) Cost of manufactured goods
8. Complete the following formula:

Gross Profit – Operating Expenses = ____________________________.
(a) Net income
(b) Operating income
(c) Gross profit
(d) Contribution margin

PRE-TEST xv
9. Which is the lowest level of report issued by a Certified Public

Accountant after developing a working knowledge of the entity and
reading the financial statements to confirm that they are in the correct
form and free from obvious material errors?
(a) Compilation
(b) Review
(c) Standard Audit
(d) Qualified Opinion
10. One metric that management can calculate to see if there was adequate
cash flow during the period to keep productive capacity at current
levels is Free Cash Flow (FCF). FCF is calculated by taking values
from the __________________.
(a) balance sheet
(b) statement of cash flows
(c) retained earnings statement
(d) income statement
11. Which of the following is the organization that is empowered to issue

statements of financial accounting standards and interpretations?
(a) AAA
(b) PCAOB
(c) FASB
(d) IMA
12. Which of the following is not a current asset of a business?

(a) Fixed assets
(b) Accounts receivable
(c) Inventories
(d) None of the above, since all are current assets
13. Which of the following are assets?

(a) Inventories
(c) Land
(d) All of the above
14. Additional paid-in capital is:

(a) the same as treasury stock.
(b) a type of equity account.
(c) always preferred stock.
(d) a long-term liability.

xvi HOW TO READ AND INTERPRET FINANCIAL STATEMENTS
15. Which of the following is the asset name for amounts due from
customers for sales made or services rendered on account?
(a) Promissory notes
(c) Accruals
(d) Interest receivable
16. Which of the following is not one of the inventory accounts related to
the products that the company sells?
(a) Raw materials
(b) Supplies
(c) Work-in-process
(d) Finished goods
17. Which of the following inventory methods would result in maximizing

net income during times of rising prices?
(a) Last in, first out
(b) First in, first out
(c) Average cost
(d) Specific identification
18. Which of the following inventory methods would result in minimizing

(c) Average cost
19. Which of the following is not a current liability?

(a) Accounts payable
(b) Notes payable (due in six months)
(c) Dividends payable
(d) Bond due in ten years
20. Which of the following long-term liabilities creates a lien on company

property?
(a) Bond payable
(b) Mortgage payable
(c) Zero coupon bond
(d) Debenture
21. Which of the following liabilities rarely carries an interest charge?

(b) Notes payable
(c) Bonds payable
(d) Mortgage payable

PRE-TEST xvii
22. Which of the following income statement formats shows the most
detail?
(a) Single step
(b) Multi-step
(c) Cost-of-goods-sold step
(d) Contribution margin income statement
23. The source of payment of current liabilities usually is derived from

__________________ assets.
(a) long-term
(b) net
(c) current
(d) permanent
24. Under accrual accounting rules, generally, a revenue:

(a) is any cash inflow into a business during the accounting period.
(b) is the result of delivering or producing goods and rendering
services.
(c) can include an increase in equity from transactions that are not
central to the purpose of the firm.
(d) is shown on the statement of cash flows.
25. __________________ income is a company’s change in total

stockholders’ equity from all sources other than the owners of the firm.
(a) Net
(b) Extraordinary
(c) Comprehensive
(d) Interest

Understanding Financial
1
Statements
Learning Objectives
By the end of this chapter, you should be able
to:
• Identify the two major users of accounting in-
formation and explain their specific needs.
• List the various entities that influence the de-
velopment of Generally Accepted Account-
ing Principles (GAAP).
• Describe the basic principles of accounting
and financial statement preparation.
• Explain the differences between financial
statements that have been audited as opposed
to those that are only reviewed or compiled.
• Identify and explain the limitations of finan-
cial statements.
INTRODUCTION
The goal of this course is to help you work with financial statements and to
have a better understanding of what these critical reports convey to managers,
creditors, investors, and regulators. Whether you look to invest, to lend, or
simply to manage the resources of a business, you will benefit from delving
deeper into the underlying assumptions and the pointed messages found in
financial statements.
Financial statements communicate important facts about a firm. Users
of financial statements rely on these facts to make decisions that affect the
well-being of enterprises and the general health of the economy. Therefore,
it is essential that financial statements be both reliable and useful for decision
making. Useful accounting and finance data is information that makes man-
agers more intelligent—it makes managers better decision makers. Reliability
1
2 HOW TO READ AND INTERPRET FINANCIAL STATEMENTS
and usefulness are critical for informed decision making. The concept of useful
information is particularly important. Accounting principles and practices have
at their origins the weighty goal of usefulness, and management accounting
(to be discussed in a subsequent section of this chapter) is almost exclusively
guided by the need for management to have information that is useful in the
context of decision making. For the management accountant, the objective of
usefulness serves as the primary guiding light.
ACCOUNTING IS MORE AN ART THAN A

SCIENCE
Accounting is a system that collects and processes (analyzes, measures, and
records) financial information about an organization and reports that infor-
mation to decision makers (Libby, Libby, and Short, 2011).
Accounting is often called an art because it is never completely defined;
it is in a state of constant flux. This state of change is necessary because of:
• The changing needs of financial statement users
• The pressures of regulatory bodies
• The internal needs of management
Users of financial information fall into two primary groups: internal and
external. The next two sections of this chapter elaborate on the different needs
of these two types of users.
Internal Users
Internal users are managers who use financial information to make decisions
that affect day-to-day operations and to plan future operations. Managerial
accounting systems meet the needs of internal users. Managerial accounting
provides information that enables better internal decision making and can in-
clude:
• The cost of a product or service
• The price to charge for a product or service
• The contribution margin of a product or service
• Budgets
• Variances
• Whether to lease or purchase an asset
• Whether to make or buy a product
• Investment analysis
• Capital rationing
Internal users’ needs are often quite different from those of external
users. Whereas the guiding principle of managerial accounting (for internal
users) is simply usefulness, the rules that dictate the reporting of financial ac-
counting information to external users are much more specific and compli-
cated.

UNDERSTANDING FINANCIAL STATEMENTS 3
External Users
External users are not involved in day-to-day operations of the firm, although
they do have an interest in the results of those operations. They typically need
financial information and receive it in the form of annual reports (i.e., reports
to stockholders), quarterly reports (filed with the U.S. Securities and Exchange
Commission), and audited financial statements (balance sheet, income state-
ment, and statement of cash flows). External users may be one or more of the
following:
• Common stock investors
• Bondholders
• Vendors
• Banks
• Financial analysts
• Potential vendors
• Creditors
• Credit agencies
• Union and trade representatives
• Customers
• Government regulatory agencies, such as the Securities and Exchange
Commission (SEC)
• The Public Company Accounting and Oversight Board (PCAOB)
External users work with information generated by the firm’s financial
accounting system and especially the output of that system: the financial state-
ments. Financial accounting is the process that results in the preparation of
financial statements for use by external users. Financial accounting is gov-
erned by specific rules and procedures, principles, and accepted concepts. We
call the rules of financial accounting Generally Accepted Accounting Prin-
ciples (GAAP). This course does not attempt to educate the student on the
details of GAAP; however, it is valuable for the financial statement user to
know that the rules of GAAP are guiding lights helping the accountant pre-
pare reliable reports. GAAP helps increase the confidence that readers of fi-
nancial statements have in the values that are reported.
GAAP has not always been in place. As American industry grew in size
and complexity and state and federal tax laws evolved, it became necessary
to develop a set of guidelines to regulate the preparation of financial state-
ments so that shareholders (nonmanagement owners), taxing authorities, cred-
itors, and other interested parties could assess the financial condition of
companies consistently. It also would guarantee that users of financial infor-
mation would have statements that were reliable. Various organizations re-
sponded favorably to this need for generally accepted accounting principles.
Although accounting has been around since around the time of Colum-
bus (late 1500s), it is an ever-evolving practice, and through the years, various
organizations have taken the lead in developing a theory base for accounting.
In 1973, a degree of stability was achieved with the establishment of the Fi-
nancial Accounting Standards Board (FASB). The goal of the FASB was, and
still is, to develop a constitution or broad conceptual framework for financial
accounting. However, for a principle or concept of accounting to be consid-

ered “generally accepted,” it must have substantial support from several in-
terest groups. One important group is the Securities and Exchange Commis-
sion (SEC), whose role is explained in a later section of this chapter.
FASB is an independent organization consisting of seven full-time members
from both the accounting profession and the business sector. The major objective
of FASB is to review and research accounting issues and to establish accounting
standards. The standard-setting process of FASB is open to the public, and public
participation is strongly encouraged. The process of establishing a standard can
be time-consuming; some standards have taken more than a decade to establish.
FASB is independent of the AICPA and is empowered to issue statements
of financial accounting standards as well as interpretations of those statements
or the statements of other bodies. FASB may issue new statements, modify or
revoke existing standards of proceeding boards, and interpret any existing
principle.
Major accounting research projects are undertaken by a FASB task force
of outside experts. This task force studies existing literature related to the
major project and then issues a discussion memorandum that identifies the
basic premises of the topic. The discussion memorandum is available to the
general public, and interested parties are encouraged to comment either in
writing or verbally at a public hearing. Once comments from interested parties
have been considered by FASB, FASB meets to resolve pending issues. (Once
again, these FASB meetings are open to the public.)
The meeting results in an exposure draft, which is a statement of specific
recommendations. An exposure draft requires a majority approval from FASB in
order for it to be issued to the public. The accounting profession and the business
community have the opportunity to respond to the exposure draft; at the end of
the exposure period (usually at least 60 days), all comments from interested par-
ties are reviewed by FASB. FASB’s review of reactions and comments is analyzed,
and the end result is either the issuance of a statement of financial accounting
standards or, in some cases, the abandonment of the project.
FASB statements can create a new standard or re-examine an old one. A
FASB interpretation clarifies existing FASB opinions or those of FASB’s pred-
ecessors. This prolific body reflects both the rapidly changing profession of
accounting and the profession’s need to police itself. FASB would rather police
the profession than respond to threats of regulatory action by the government.
Despite a very effective self-regulatory role played by the accounting
profession and FASB, the federal government does influence accounting prac-
tices through the SEC. With legislation in 1934, Congress formed the SEC to
regulate the issuance and trading of securities by public corporations. The
SEC issues Accounting Series Releases (ASRs) on accounting matters affect-
ing the financial reporting by publicly held companies. The primary aim of
the SEC is to provide potential investors with accurate, consistent information
and to protect them from abuses and false or misleading information.
As a result of the Sarbanes–Oxley Act of 2002, the Public Company Ac-
counting Oversight Board (PCAOB) was created. The PCAOB website
(pcaobus.org) states that “the PCAOB is a nonprofit corporation established
by Congress to oversee the audits of public companies in order to protect the
interests of investors and further the public interest in the preparation of in-

formative, accurate, and independent audit reports.” Since the PCAOB issues
auditing standards, it has an impact on the quality of information reported in
the audited financial statements of publicly held corporations.
Several other groups and organizations are also influential in the devel-
opment of accounting standards.
The American Accounting Association (AAA) is composed of accounting pro-
fessors and practicing accountants. The AAA serves as a critic in apprais-
ing accounting practice and recommends improvements through its
quarterly publication, The Accounting Review.
The Institute of Management Accountants (IMA) provides accounting re-
search and education for the internal accountant. In addition, the IMA
awards the Certificate in Management Accounting (CMA), a well-rec-
ognized professional accounting designation.
The state societies of CPAs provide forums and boards for the discussion of
FASB pronouncements and other matters of importance to the profession.
The Internal Revenue Service (IRS) has a strong influence over the use of
accounting methods. Since tax and financial accounting often have dif-
ferent objectives, managers must decide which policies will minimize tax
effects while maximizing income. These conflicts often lead to tax-to-
book differences in income.
There is no end to the evolutionary process involved in the development
of generally accepted accounting principles, as the needs and requirements
of business and government are always changing.
Think About It . . .
Answers appear at the end of this chapter.
1. Why is accounting more an art than a science? ___________________________________
_________________________________________________________________________
_________________________________________________________________________
2. What dictates the standards to be used by management accountants when preparing

information for internal use?___________________________________________________
_________________________________________________________________________
_________________________________________________________________________
3. Why is it necessary that financial information to be used by external users be reported in

accordance with GAAP? _____________________________________________________
_________________________________________________________________________
_________________________________________________________________________
“Think About It” continues on next page.

Think About It continued from previous page.
4. Match the financial information with the typical user of that information.
A = Internal User B = External User C = Both
___ Analysis of cost components of a product
___ Budget
___ Annual report to stockholders
___ Lease versus purchase analysis
___ Balance sheet
___ Income statement
BASIC CONCEPTS AND PRINCIPLES OF

FINANCIAL ACCOUNTING AND FINANCIAL
STATEMENTS
The various bodies discussed previously exist to ensure that different financial
statements will be uniformly useful. To this end, accountants make several
basic assumptions. They are:
• There exists an accounting entity whose activity can be kept separate from
that of its owners or other business units (separate-entity assumption).
• The enterprise is assumed to have a life that will continue beyond the cur-
rent accounting cycle (going-concern assumption). Unless stated or dis-
closed as otherwise, when a user reads financial statements, he or she is to
assume that the business is to operate indefinitely into the future. That is
why liquidation values of assets are not important. Liquidation values are
irrelevant as of the balance sheet date as a going-concern enterprise is not
on the verge of liquidation. On the other hand, if the going-concern as-
sumption cannot be made, that fact must be disclosed in the financial state-
ments, and auditors must also add a “going-concern” explanatory paragraph
to their audit reports to call attention to the doubts they might express
about business continuity.
• Money is used as a unit of measurement. Accounting records are kept in
monetary units and therefore in the United States, items revealed on the
balance sheet, income statement, and cash flow statement are all in dollars
and cents.
• The measurement of the activity of a firm is broken down into accounting
cycles of short duration, such as a year. This is to allow information to be
collected and reported in a timely manner. This is called the periodicity
or time period assumption.

Along with the underlying assumptions used by accountants when

preparing financial statements, several basic financial accounting principles
can be summarized as follows:
• Historical cost is used to record the activities and transactions of a firm. His-
torical cost is a verifiable item and provides an objective basis for valuation.
• Revenue recognition is made when the earnings process is complete and an
exchange transaction has occurred.
• Attempts are made to match related costs to recognized revenues (matching
principle). There are generally two types of cost: product and period. Product
costs are usually included as part of inventory and will be recognized in fu-
ture periods after the sale of inventory. Period costs are those that are charged
to current operations, such as rent.
• Full disclosure requires that the information provided be of sufficient detail
and comprehensive enough to allow the user to make adequate decisions.
There are conflicting forces at work in this principle that cause trade-offs
among the need for detail, the ability of the accountant to condense detail
and keep it understandable, and the need to do this in a cost-effective man-
ner. Notes to the financial statements provide additional information be-
yond the numbers of the financial statements. For example, a note to a
financial statement can describe the particular inventory method used to
value the ending inventory and cost of goods sold. Methods such as last in,
first out; first in, first out; and average cost are all possible ways of valuing
inventory and all give different results. Someone analyzing the financial
statements who wants to understand how the inventory was valued can de-
termine that by reading the disclosures in the notes. Other examples of
common notes to financial statements include disclosures regarding depre-
ciation methods, leases, fair value reporting, and related party transactions.
• Conservatism prevails; it is the method least likely to overstate assets or in-
flate income. This underscores the general rule that unfavorable events are
recorded immediately. The recording of apparently favorable events must
wait until the favorable outcome is assured. This also leads to the practice
that if alternative accounting methods are available, the accountant should
choose the one having the least favorable effect on net income and total
assets.
• Materiality requires that judgment be used in determining how some trans-
actions are handled. It is similar to the concept of an order of significance;
an adjustment for depreciation, for example, may be immaterial (insignif-
icant) for a large company. Therefore, the adjustment may not be made. If
a small company chooses not to make the entry, however, the financial state-
ment could be seriously distorted. It is also required that all material dis-
closures be made to readers of financial statements. This includes all
additional information that if known by an investor or creditor could in-
fluence those parties deciding to invest in or grant credit to the company
represented by the financial statements.

• Accrual accounting is used as the basis for recording transactions under gen-
erally accepted accounting principles (GAAP). That is, an expense is
recorded when incurred regardless of when the cash payment for the ex-
pense is made. Revenues are recorded when a sale is made, not necessarily
when cash flows occur.
For each of the following, identify with a C (Conservatism) or an F (Full Disclosure) the related ac-
counting principle or assumption that underlies the procedure.
5. ___ Inventory should be stated at the lower of cost or market value on the balance sheet.
6. ___ Land is worth (market value) $1,000,000. It was acquired by the company 10 years ago for
$300,000 and is still listed on the balance sheet at $300,000.
7. ___ A company’s management believes that it will soon lose a law suit and that the settlement
could be substantial. However, it (management) has not been able to develop a reasonable
estimate of the settlement amount. The company’s auditors require that these facts be dis-
closed in footnotes to the financial statements.
GENERALLY ACCEPTED ACCOUNTING

PRINCIPLES (GAAP)
As was previously stated, the combination of basic assumptions and principles
make up a body of knowledge known as generally accepted accounting prin-
ciples (GAAP). These principles reflect the consensus of the accounting pro-
fessions at any given point in time. They determine:
1. What should be recorded as assets and liabilities.
2. What changes in asset values and liability balances should be recorded,
and when they should be recorded.
3. What information needs to be revealed, and how it should be revealed.
4. How the financial accounting systems should operate.
5. How the financial statements should be prepared and what statements
should be prepared.
When an accountant performs an audit of a firm’s financial statements,

he or she determines whether the statements were prepared according to
GAAP. An audit is an investigation conducted by accountants employed by a
public accounting firm. In an audit, the accountants carefully examine a com-
pany’s accounting systems, records, and internal controls. This examination

enables the accounting firm to issue an opinion as to the fairness and reliabil-
ity of the company’s financial statements.
There are also international standards that companies operating globally
must adhere to when reporting financial position and results of operations.
International Financial Reporting Standards (IFRS) are accounting rules for
global businesses. They have been developed because it is common for share-
holders to own companies that deal in international trade and have operations
in many countries. They are particularly important for companies that have
dealings in several countries. Investors have been challenged when trying to
analyze global companies and compare financial statements of entities from
different countries with different financial reporting standards.
In the recent past, major economies such as those of the United States,
the United Kingdom, Japan, and Germany have had their own standards (ver-
sions of GAAP). The difficulty for international investors has been trying to
restate or convert accounting information from one country to another to
make financial statements comparable and more easily interpreted. The IFRS
has as its goal to harmonize or converge accounting standards used across the
globe into one set of rules. By 2015, U.S. GAAP is expected to be in harmony
with IFRS. In other words, once GAAP is aligned with IFRS, publicly traded
corporations based in the United States will be issuing financial statements
that comply with the principles of IFRS.
Auditor’s Reports
The auditor’s opinion is the result of a process of audit, analysis, and investigation.
The opinion deals with the fairness of the financial statements and their con-
formity with GAAP, and should disclose any material changes in accounting
principles. When performing financial audits of public corporations, auditing
firms also issue an audit report on internal controls. Internal controls are
processes affected by an organization’s structure, work and authority flows, peo-
ple, and accounting information systems designed to help the organization ac-
complish specific goals or objectives. One important objective of internal controls
is to help promote accurate and reliable financial reporting. Internal controls
have existed in businesses for decades but there has been greater emphasis on
internal controls in recent years with the enactment of the Sarbanes–Oxley Act
of 2002, which required improvements in internal controls along with careful
documentation of such controls by auditors in U.S. public corporations.
There are two other lower-level reports that an auditor can issue: compi-
lation and review. The financial statement user should be aware of the level of
involvement contained in each report (audit, compilation, and review). This
awareness allows the analyst to form a judgment on how much reliance can
be placed on the financial statements that accompany these reports.
Audit
The greatest level of assurance of GAAP compliance is attained when an audit
is performed. In an audit, the accountant performs extensive tests of transac-
tions and internal controls in order to be reasonably certain that accounting
systems perform as required by GAAP.

According to AU 150 section paragraph .07 of the Generally Accepted

Auditing Standards, an independent auditor “plans, conducts, and reports the
results of an audit in accordance with generally accepted auditing standards.
Auditing standards provide a measure of audit quality and the objectives to
be achieved in an audit.” An audit is critical to providing users of financial
statements with the confidence they need to “trust the numbers.”
During an audit, external auditors conduct an extensive investigation
(auditing procedures) into many aspects of the business and accounting sys-
tems. Confirmation letters are mailed by the accountant to verify such items
as cash, receivables, and major liabilities.
In an audit, extensive verification work is done on balance sheet items
and their valuations. In addition, auditing standards call for full disclosure of
major nonfinancial items and events, and the auditor works to verify that these
major items are revealed as footnotes to the statements.
The audit process concludes with the issuance of an auditor’s opinion.
The second paragraph (opinion paragraph) in the unqualified, short-form
audit report used by independent auditors contains the attestation to the in-
tegrity of the financial statement. Standard audit reports contain a statement
(opinion paragraph) very similar to the following:
In our opinion, the financial statements referred to above present

fairly, in all material respects, the financial position of XYZ, Inc., at
December 31, 20XX, and the results of its operations and its cash
flows for the year then ended, in conformity with accounting prin-
ciples generally accepted in the United States of America.
Review
The next level of report is the review. In doing a review, the accountant per-
forms inquiry and analytical procedures. An inquiry involves asking manage-
ment about the company’s accounting methods for recording, classifying, and
summarizing transactions as well as those methods used for accumulating in-
formation for disclosure in the financial statements, and reading the minutes
that detail actions taken at meetings of stockholders, boards of directors, etc.
The analysis performed by an accountant when conducting a review is
much less extensive than auditing procedures and consists of:
• Comparison of prior years’ results and balances with current year results
and balances
• Comparison of budgets and forecasts with actual results
• Financial statement analysis, including ratio analysis
Financial statement analysis is done to see whether the current financial

balances and results meet the accountant’s requirement for reasonableness. It
is hoped that the comparisons and analytical techniques will disclose any gross
errors made in recording assets, liabilities, revenues, and expenses.
With a review, the analyst has a greater degree of assurance that the state-
ments are materially correct than that obtained with a compilation. However,
since an audit is not performed in a review, the accountant cannot express the

opinion that the statements are prepared in accordance with GAAP.

Compilation
The lowest level of report is the compilation. When doing a compilation, the
accountant is required only to have a working knowledge of the industry and
to read the financial statements to see if they are in the correct form and free
from obvious material errors. The compilation is a service provided by ac-
countants that meets the objective of helping management present financial
information without performing auditing procedures or providing any assur-
ance about the quality of the information being reported. For example, a com-
pilation involves no testing of underlying accounting records, no inspection
of source documents, no confirmation of account balances (such as accounts
receivable) and no observation of accounting procedures (such as the counting
of merchandise inventory).
The compilation report is issued only for nonpublic entities and it clearly
states that the accountant has “not audited or reviewed the accompanying fi-
nancial statements” and stresses that the accountant is not expressing an opin-
ion or providing any assurance about whether the financial statements are
accurate.
With a compilation, a reader of the financial statements is assured only
that the form is correct, that the math is correct, and that nothing appears un-
usual. With a compilation report the accountant (CPA) does not render an
opinion about the financial statements’ compliance with GAAP. A GAAP
opinion is the result of an audit, and an audit is not performed in a compilation
engagement.
8. How is compilation of financial statements different from an audit of financial statements

from the standpoint of the user (reader, financial analyst, credit analyst, etc.)?
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
9. As an external statement user, explain why you would be correct in asking for audited
financial statements as opposed to those that were compiled or reviewed by an accountant.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

LIMITATIONS OF FINANCIAL STATEMENTS

The information contained in financial statements should not be seen as a
complete picture. Although the statements may have the appearance of ex-
actness, certain limitations exist, and many important factors, including qual-
itative variables, are not captured within the financial statements and their
related disclosures. For example, a balance sheet provides no way to quantify
the morale of employees or the creative and innovative approaches taken by
management. The depth of experience of management and the competitive
advantages that a firm enjoys because of the knowledge and skills of its em-
ployees also do not show up in the financial statements.
Information resources (including the company’s information processing
capabilities), the valuable strategic information contained in its files and
servers, and the value of its website with its “hits and unique visitors” cannot
be measured in terms of debits and credits. Nor can the value of the human
resources of a company be represented on a balance sheet.
Many measures of competitiveness are not reflected in financial state-
ments. A company’s brand equity and its competitive standing vis-à-vis other
companies in its industry are hard to judge by examining financial statements.
Even when comparing similar firms, difficulties can arise as a result of compa-
nies using acceptable but different methods of accounting for similar transac-
tions. And despite all the rules, conservative approaches, and accuracy built
into generally accepted accounting principles, management uses many esti-
mates when preparing financial statements. Although much accounting infor-
mation is based on objective evidence, some accounts, including receivables,
inventory, and depreciation, are estimates and therefore subject to error.
Nonmonetary yet important facts are not disclosed in financial state-
ments. In some businesses, management has supplemented the internal re-
porting of financial results with what is called the balanced scorecard. The
balanced scorecard not only reports the traditional measures of financial per-
formance—data and metrics gleaned from the financial statements—but also
reports measures related to customer satisfaction and competitiveness. A com-
plete discussion of the balanced scorecard is beyond the focus of this text;
however, its use and popularity in the 21st century attest to the limitations of
the messages of financial statements when it comes to monitoring strategic
performance.
Another limitation of financial statements is that they are not presented
in real time—they are, in fact, historic. Financial statement information can
be stale. The balance sheet is only a snapshot of a very dynamic situation that
was a reality some time ago. Balance sheet values can change from minute to
minute, and although much internal reporting is done in real time, external
reporting (financial statements) cannot be done in real time. Audited state-
ments take many months to be issued. An income statement is only a reflection
of the revenues and expenses of a period that has already passed. Market
trends and other changes in the market place are rapid and can change many
assumptions after financial statements have been issued.
Historical costs, which provide the basis for most of the assets reported
on a balance sheet, may not bear any resemblance to and are not usually

correlated to current market values (with a few exceptions, such as inventory

and marketable securities). In addition, historical costs may seem irrelevant
once inflation is considered. The inflationary trend in this country has weak-
ened the reliability of financial statements because conventional reporting
has not accounted for the changing dollar value. Since the 1930s, the purchas-
ing power of the U.S. dollar has declined significantly as a result of inflation.
On the liability side of things, contingent liabilities (obligations that will
occur if some other event happens) are not reflected on the balance sheet.
Some obligations, such as certain leases, are also kept off the balance sheet.
Increases in sales volume near the current end of the price spiral may be
the result of a greater number of units sold. But if the unit volume equals that of
many previous years, the selling price would have to be increased to keep abreast
of the rising level of costs. Therefore, comparison of information over an ex-
tended period, without allowing for cyclical trends in the economy, can lead to
inconsistent, misleading conclusions. In addition, assets that are recorded and
reported at historical cost can be grossly undervalued in terms of today’s dollars.
The list of items not disclosed in financial statements but having an im-
portant impact on decision makers is long. Credit ratings, future contractual
commitments, some contingent liabilities, the effectiveness of research and
development, the loyalty of customers, the loyalty and integrity of employees,
and the quality of the products are all considerations. When a user does a
thorough analysis of a company, many of these factors must be taken into ac-
count, even though the accounting records will not reveal them. Therefore,
there are always some supplemental sources of relevant data that must be
gathered (beyond the ledgers and statements) and considered when trying to
get a holistic picture of an entity.
10. List five events that would not be reflected in the “numbers’’ of financial statements but could
have a significant impact on the future operation and condition of a firm.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
11. The Purple T-Shirt Company sells its entire product online. Its CPA prepares annual financial
statements showing its cash flows, assets, liabilities, equity, revenues, expenses, and net
income. The financials are done in accordance with GAAP and management analyzes the
statements using traditional methods (such as financial ratios). However, because the
business is so dependent on its web business, management would like to see more
measures of performance, especially those related to the website. What do you think
management wants to track and analyze beyond what is disclosed by and asserted to in the
financial statements?

_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
Accounting is art rather than a science because it is never fully

defined; it is always in a state of change. Managerial account-
ing systems meet the needs of internal users, whereas external
users’ needs are met by financial accounting systems. The sin-
gle guiding principle of managerial accounting is usefulness,
while financial accounting is governed by generally accepted
accounting principles (GAAP).
Many organizations have an impact on the development of accounting
principles, but no organization has more influence than the Financial Ac-
counting Standards Board (FASB). Other groups, including the American In-
stitute of Certified Public Accountants and the Institute of Management
Accountants, are also influential in the development of accounting standards.
This chapter summarized some of the basic concepts and principles of
accounting used in the preparation of financial statements. It is critical that
users of financial statements understand these concepts to make the analysis
of such statements most meaningful. Accounting information users also need
to understand the different levels of auditor’s reports, including the stan-
dard/unqualified (clean opinion) report, qualified report, compilation, and
review. Unqualified and qualified auditor’s reports and an auditor’s review
give some level of assurance about the fairness and accuracy of reports (al-
though some are quite limited). A compilation is the lowest level of an ac-
countant’s report and only assures that correct form was used and that the
unaudited financial statements are free from obvious material errors. No au-
diting procedures are performed in the case of a compilation.
Nonaccounting considerations and limitations that affect the analysis and
interpretation of financial statements need to be understood by financial state-
ment users and the disclosures made within the notes to the financial state-
ments must also be reviewed and understood to get a clear picture of the
financial health of a company.

Review Questions
INSTRUCTIONS: Here is the first set of review questions in this course. Answering the questions fol-
lowing each chapter will give you a chance to check your comprehension of the concepts as they are presented
and will reinforce your understanding of them.
As you can see below, the answer to each numbered question is printed to the side of the question.
Before beginning, you should conceal the answers in some way, either by folding the page vertically or by
placing a sheet of paper over the answers. Then read and answer each question. Compare your answers
with those given. For any questions you answer incorrectly, make an effort to understand why the answer
given is the correct one. You may find it helpful to turn back to the appropriate section of the chapter and
review the material of which you are unsure. At any rate, be sure you understand all the review questions
before going on to the next chapter.
1. Accounting as a profession and as a way of reporting financial 1. (d)

information experiences changes over time. Accounting principles,
rules, and procedures change over time as a result of all of the
following except:
(a) the changing needs of financial statement users.
(b) pressures from regulatory bodies such as the SEC.
(c) the needs of management.
(d) the U.S. Congress, which requires revisions of accounting rules
every five years.
2. External users of financial statements have access to all of the 2. (d)
following reports except:
(a) the balance sheet.
(b) the income statement.
(c) the statement of cash flows.
(d) budgets.
3. Which of the following organizations has as its objective to 3. (b)
review and research accounting issues and to establish accounting
standards in the United States?
(a) PCAOB
(b) FASB
(c) GAAP
(d) SEC
4. Which accounting principle or assumption would guide a 4. (c)
bookkeeper or accountant to record a sale of a product because
the “earnings process is complete and an exchange has taken place”?
(a) Going concern
(b) Historical cost
(c) Revenue recognition
(d) Full disclosure

5. Which of the following is an assumption that the company reflected 5. (a)

in the set of financial statements would be viable and carry on its
business indefinitely into the future?
(a) Going concern
(b) Historical cost
(c) Revenue recognition
(d) Full disclosure
ANSWERS TO “THINK ABOUT IT . . . ”

QUESTIONS FROM THIS CHAPTER
1. It is never completely defined; it is ever-changing because the needs of financial
statement users, regulatory bodies, and others are always changing.
2. Managerial accounting provides financial information that is useful in making
decisions. Since usefulness is the only guiding light, no standards are necessary.
Management accountants prepare internal reports such as budgets, variances, pricing
reports, and capital expenditure analyses.
3. GAAP is a set of guidelines that enables external financial users to assess financial
conditions consistently. GAAP also assures that these users will be confident that
financial statements are reliable.
4. A
A
B
A
C
C
5. C
6. C
7. F
8. The user of a financial statement that has been audited by external auditors has a much
higher confidence level that the statements have been prepared in accordance with
generally accepted accounting principles (GAAP). If it is a clean opinion (unqualified
opinion), there is also an assumption that the statements are reasonably free from errors
and material misstatements. A qualified opinion will tell the reader that except for
certain issues, the statements are in good shape, whereas an adverse opinion will
disclose serious problems with the financial statements. With a compilation report, the
accountant does not render an opinion about the financial statements’ compliance with
GAAP. The accountant performs limited procedures and relies very heavily on
management when “compiling” financial statements. A GAAP opinion is the result of
an audit, and an audit is not performed in a compilation engagement.

9. Audited statements: You can be confident that the statements were reviewed by an
independent third party (CPA) and an opinion stating whether the statements were
presented fairly and in conformance with GAAP has been made. More extensive
procedures have been used by the auditor/accountant in issuing an audit report as
opposed to a review or compilation. A review does involve more extensive procedures
than a compilation; however, only inquiries of management and analytical procedures
are done in a review whereas a compilation only assures that the form of the financial
statements is correct, the math is correct, and that nothing appears unusual, but no
opinion is issued by the accountant as to compliance with GAAP.
10. There can be any number of correct answers, but examples could include:
management expertise, product quality, trade secrets, valuable patents, company
reputation and goodwill, product quality, credit rating, effectiveness of R&D (research
and development), and the loyalty and integrity of employees.
11. With a website, profitability is important (net income); however, other measures are
also critical success factors such as page views, unique visitors, bounce rates, and
website conversion rates. Those types of metrics cannot be generated or derived from
a set of financial statements.

Types of Financial
2
Statements
Learning Objectives
to:
• Identify the four key financial statements.
• Describe what each type of financial state-
ment presents to the reader.
• Identify the major components of each type
of financial statement.
• State the basic accounting equation.
• State the formula for the statement of re-
tained earnings.
• List the things to look for in the notes to the
financial statements.
INTRODUCTION
Chapter 2 will familiarize you with the four key financial statements: the bal-
ance sheet, the income statement, the statement of retained earnings, and the
statement of cash flows. The accounting profession strives to provide the fi-
nancial statement user with a consistent, informative document that discloses
major revenue, expense, asset, liability, and equity balances in an accurate
manner. This consistent disclosure is especially important to people outside
a firm, such as an outside financial analyst, because the financial statement
may be one of the few sources of company information available.
To meet generally accepted accounting principles, all financial state-
ments contain the following:
1. The auditor’s opinion
2. Balance sheet
3. Income statement
19
4. Statement of retained earnings

5. Statement of cash flows
6. Notes to the financial statements
In addition to these six items, the financial statements may contain op-
tional supplementary schedules for further information.
ELEMENTS OF FINANCIAL STATEMENTS

The Financial Accounting Standards Board (FASB), in its Statement of Fi-
nancial Accounting No. 3, defined the elements of financial statements as fol-
lows (FASB, 1980):
Assets
Assets are probable future economic benefits obtained or controlled by a par-
ticular entity as a result of past transactions or events.
Liabilities
Liabilities are probable future sacrifices of economic benefits arising from
present obligations of a particular entity to transfer assets or provide services
to other entities in the future as a result of past transactions or events.
Equity
Equity is residual interest in the assets of an entity that remains after deduct-
ing its liabilities. In a business enterprise, the equity is the ownership inter-
est.
Investments by Owners
Investments by owners are increases in net assets of a particular enterprise
resulting from transfers to it from other entities of something of value to ob-
tain or increase ownership interests (or equity) in it. Assets are most com-
monly received as investments by owners, but that which is received may also
include services, or satisfaction, or conversion of liabilities of the enterprise.
In corporations, investments by an owner can take various forms, including
the purchase of common stock and preferred stock.
Distributions to Owners
Distributions to owners are decreases in net assets of a particular enterprise
resulting from transferring assets, rendering services, or incurring liabilities
by the enterprise to owners. Distributions to owners decrease ownership in-
terests (or equity) in an enterprise. In a corporation, distribution to owners is
usually in the form of a cash dividend.

TYPES OF FINANCIAL STATEMENTS 21
Revenues
Revenues are inflows or other enhancements of assets of an entity or settle-
ment of liabilities (or a combination of both) during a period resulting from
delivering or producing goods, rendering services, or other activities that con-
stitute the entity’s ongoing major or central operations.
Expenses
Expenses are outflows or other using-up of assets or incurrence of liabilities
(or a combination of both) during a period resulting from delivering or pro-
ducing goods, rendering services, or carrying out other activities that consti-
tute the entity’s ongoing major or central operations.
Gains
Gains are increases in equity (net assets) from peripheral or incidental trans-
actions of an entity and from all other transactions and other events and cir-
cumstances affecting the entity during a period, except those that result from
revenues or investments by owners.
Losses
Losses are decreases in equity (net assets) resulting from peripheral or inci-
dental transactions of an entity and from all other transactions and other
events and circumstances affecting the entity during a period, except those
that result from expenses or distributions to owners.
These definitions are formal, somewhat difficult to understand, and all-
encompassing. To simplify the definitions of the financial statement elements
we will explore first in this chapter—assets, liabilities, and equity—we will
use the following definitions:
• Assets are things of value owned by a business.
• Liabilities are debts owed by a business.
• Equity represents the interest or rights due the owners or shareholders after
all liabilities have been settled.
Assets, liabilities, and equity are presented on the balance sheet and represent
balances at a certain point in time. The balance of the elements at that point
in time is the cumulative balance of all transactions since the inception of the
business.
The balance sheet elements are affected by other account balances that
are not reported on the balance sheet, such as distributions (dividends) to
owners, revenues, expenses, gains, and losses. These items—specifically rev-
enues and expenses—summarize transactions over a period of time, for in-
stance, from January 1 to December 31 of a particular year, and are presented
on the income statement and the changes in equity statement. Revenue, ex-
pense, gains, and loss accounts are often called temporary accounts since their
balances are closed into the equity account at the end of the period and are
set to zero to begin summarizing a new period. The process of closing

accounts is similar to resetting a scoreboard back to zero at the end of a game.

To this point we have briefly explored the elements of financial state-
ments. The following sections review the components of the various state-
ments and their major groupings. We begin exploring the components of
financial statements by first looking at the balance sheet.
THE BALANCE SHEET

The balance sheet is a snapshot of a business at a given date. Also called a
statement of financial position or a statement of financial condition, the bal-
ance sheet identifies a business’ assets, liabilities, and owners’ equity as of a
certain date. An example of a comparative balance sheet is shown in Exhibit
2–1. A comparative balance sheet shows balances of accounts as of two dates.
The balance sheet is a cumulative document representing the current balances
of the various accounts since the inception of the business to a given point in
time.
The balance sheet is the line-by-line version of the basic accounting
equation:
Assets = Liabilities + Owners’ Equity
The balance sheet is subdivided into subsections of types of assets, liabilities,

and owners’ equity.
Assets
Assets can be subdivided into four major categories:
1. Current assets
2. Long-term investments
3. Property, plant, and equipment, including fixed assets (tangible and intan-
gible) and wasting assets (natural resources)
4. Other assets
Current Assets
Current assets are those that will most likely be converted into cash, be sold,
or be consumed within a period of one year or within the normal operating
cycle of the business. Under the general classification of assets, they form the
first subcategory in that they are listed first on the balance sheet. Examples
of current assets include:
• Cash
• Accounts receivable (money owed to the company from customers)
• Inventories

xhibit 2–1
Example Company Balance Sheets, Years Ended December 31, 20X1
and December 31, 20X2
20X2 20X1
Assets
Current Assets:
Cash $ 50,000 $
Marketable Securities 116,006 50,000
Accounts Receivable 247,856 224,659
Inventories 1,343,670 1,308,100
Prepaid Expenses 2,247 0
Total Current Assets 1,759,779 1,620,747
Fixed Assets:
Property, Plant, and Equipment 860,307 803,518
Less: Accumulated Depreciation 543,426 477,994
Total Fixed Assets 316,881 325,524
Other Assets 6,537 8,537

Total Assets $2,083,197 $1,954,808
Liabilities and Owners’ Equity

Current Liabilities:
Notes Payable—Bank $ 55,000 $ 85,000
Current Portion of Long-Term
Debt 1,850 5,553
Accounts Payable—Other 642,237 535,610
Notes Payable—Other 134,692 144,692
Accrued Expenses 46,980 47,913
Accrued Income Taxes 10,743 16,064
Total Current Liabilities 891,502 834,832
Long-Term Debt:
Notes Payable—Bank 22,818 10,488
Less: Current Portion 1,850 5,553
Net Long-Term Debt 20,968 4,935
Total Liabilities 912,470 839,767
Owners’ Equity
Common Stock, issued and
Outstanding: 10,000 Shares $10 Par 100,000 100,000
Additional Paid-In Capital 22,643 22,643
Retained Earnings 1,070,584 992,398
1,193,227 1,115,041
Less: Treasury Stock 22,500
Total Owners’ Equity 1,170,727 1,115,041

Total Liabilities and
Owners, Equity $2,083,197 $1,954,808

Long-Term Investments
Long-term investments include such assets as:
• Stocks and bonds owned by the business
• Land held for future use or speculative purposes
• The cash surrender value of life insurance policies
• Investments set aside in special funds, such as pension or plant-expansion
funds
Property, Plant, and Equipment

Property, plant, and equipment, also called fixed assets, are used in the oper-
ation of the business and have a useful life of more than one year. They may
be broken down further into:
• Tangible fixed assets
• Intangible fixed assets
• Natural resources
Property, plant, and equipment can be thought of as assets that businesses

use to produce and distribute goods and services.
Other Assets
This is a catch-all for assets that cannot be classified properly elsewhere. Ex-
amples include:
• Long-term, prepaid expenses
• Refundable deposits on long-term leases
• Organization costs

1. Match the following accounts with the section of the balance sheet in which they appear. Use
the letters CA to signify current asset, LTI to signify long-term investment, and PPE to signify
property, plant, and equipment.
A. _____ Stocks owned by the firm

B. _____ Natural resources owned by the company
C. _____ Cash surrender value of life insurance policies
D. _____ Cash
E. _____ Accounts receivable
F. _____ Intangible fixed assets
G. _____ Tangible fixed assets
H. _____ Land held for speculation
I. _____ Inventories
J. _____ Investment set aside for plant expansion

Liabilities
Liabilities are usually classified in the following major subcategories:
• Current
• Long-term
Let’s first look at the current liabilities, which, like the current assets, are
listed prior to long-term items.
Current Liabilities
Current liabilities are debts and other liabilities owed by the company that
will be satisfied within one year. Cash flow from the sale or liquidation of cur-
rent assets will, under ordinary circumstances, be used to satisfy the current
liabilities. Current liabilities include:
• Accounts payable
• Wages payable
• Taxes payable
Liabilities that will not be satisfied within one year are classified as long term.
To be more descriptive and therefore disclose more information for the state-
ment user, information concerning interest rates, maturity dates, and the na-
ture of any security pledged for a long-term debt is usually included on the
balance sheet or in the notes to the financial statements. Examples of long-
term liabilities are:
• Unsecured bank loans that are payable over a period greater than one year
• Bonds that are issued by the firm and that will mature on a date more than
one year into the future
• Long-term mortgages
2. Match the following accounts with the section of the balance sheet in which they appear. Use
the letters CL to signify current liabilities and LTL to signify long-term liabilities.
A. _____ Accounts payable

B. _____ Taxes payable
C. _____ 30-year mortgage
D. _____ Unsecured bank loan due in 30 years
E. _____ Salaries payable

Owners’ Equity
Owners’ equity for a corporation is usually divided into four subcategories:
1. Capital stock at the par or stated value
2. Additional paid-in capital or amounts paid over par
3. Retained earnings (representing the undistributed earnings of the entity)
4. Treasury stock
Capital Stock
Capital stock is a broad description for the ownership interest in a corporation.
The true ownership interest in a corporation is called common stock. Com-
mon stock normally carries full ownership rights, including:
• The right to receive dividends
• The right to vote for directors
• The right to receive assets upon the dissolution of the company
• The right to maintain proportionate percentage of ownership in the com-
pany through the pre-emptive right to buy new shares of common stock
prior to their sale to the general public
• The right to examine the company’s books
There are also many types of nonvoting common stock and classes of
preferred stock. Preferred stock, which is also an ownership interest, may be
voting or nonvoting and usually has preference in the receipt of dividends;
thus the term preferred. This preference with respect to dividends means that
the preferred stockholder will receive the preferred stock cash dividend prior
to the common stockholder receiving a common stock cash dividend. How-
ever, unlike common stock, preferred dividends are usually fixed; for instance,
at a certain percentage of par value. A complete discussion of the various types
of stock is beyond the scope of this course, but the analyst should be aware of
the types presented in the equity section of a balance sheet. The footnotes to
a balance sheet usually contain details concerning capital stocks.

Another possible equity account is called additional paid-in capital. Additional
paid-in capital is capital contributed by stockholders and other outsiders. In
other words, it is the total in excess of the par, or stated value of the stock,
and is kept separate from retained earnings and capital stock balances. The
par or stated value is the stated amount of value per share specified in the
corporate charter. Par value is an arbitrary monetary figure that is not to be
confused with the market value of the stock. For example, if the par value of
a common stock was $100 and the company issued 1,000 shares at $150 per
share, there would be $50 per share of paid-in capital, for a total of $50,000
of additional paid-in capital. The results of this sale of stock are shown below:
Common Stock (1,000 shares, $100 par) $100,000
Additional Paid-In Capital $50,000
Total Capital $150,000

Some balance sheets, like the one shown in Exhibit 2–1, do not show an
amount for additional paid-in capital. This is because some companies do not
assign a par value to the stock; rather, the company issues no-par stock. For
example, assuming the same facts as in the previous example, with the excep-
tion that the stock being issued is no par, the total value of the stock being is-
sued, $150,000 (1,000 shares × $150 per share), would be recorded as common
stock.
Retained Earnings
Only two things can happen to a company’s earnings: They can be paid to the
stockholders in the form of dividends, or they can be reinvested in the com-
pany in the form of retained earnings. Retained earnings are accumulated
earnings that are not distributed to the shareholders; they have been retained
to provide for future growth. Retained earnings can be restricted or unre-
stricted. Restricted retained earnings do not constitute a pool of resources;
they are unavailable for disbursement as dividends.
Treasury Stock
Treasury stock is the company’s own stock that has been reacquired by the
firm. Shares of stock acquired as treasury stock have not been cancelled or
retired, but are being held by the company for possible future resale or reis-
suance. There are several reasons why a firm might repurchase its own stock.
They include:
• The company may wish to change its capital structure and may use the
proceeds from debt or another class of stock to buy back stock.
• The company may be trying to fight an unfriendly corporate takeover by
buying up the excess shares a suitor would need to gain a controlling in-
terest.
• The stock may be needed to make awards for employee stock plans or stock
option plans.
• The company may be trying to boost earnings per share.
One misconception is that treasury stock is an asset of the company. As

Exhibit 2–1 shows in the 20X2 column, treasury stock is a negative equity ac-
count—it is stock that was once issued but is no longer outstanding. Its balance
is a debit balance, and it is therefore subtracted from owners’ equity.
3. Using the following information, prepare the equity section of the balance sheet. A corpora -
tion issues 10,000 shares of $10 par value stock for $35 per share. During the year, it buys
back 2,000 shares at $35. The retained earnings balance at year end is $55,000.


Equity section of the balance sheet:
Common stock $_____
Additional paid-in capital _____
Less: Treasury stock _____
Retained earnings _____
Total equity $_____
4. Match the following descriptions with the owners’ equity account name:
A. _____ Common or preferred stock issued by the company to raise capital

B. _____ Capital contributed by owners in excess of the par value of the stock
purchased by the owners
C. _____ Accumulated earnings that provide for future growth
D. _____ Cash
E. _____ The company’s own stock that has been reacquired by the company
1. Additional paid-in capital

2. Capital stock
3. Treasury stock
4. Retained earnings
INCOME STATEMENT
The terms income statement, profit and loss statement, and statement of op-
erations all refer to the financial statement that discloses a company’s profit
or loss during a specified period of time. The income statement shows rev-
enues earned during a period of time, the expenses incurred to produce that
revenue, and the income or loss for that period.
In a previous section of this chapter, the formal definitions of the terms
revenue and expense were presented. A more informal and possibly easier set
of definitions for revenue and expense are as follows:
• Revenue—the price of goods sold and services rendered during a given ac-
counting period
• Expense—the cost of the goods and services used in the process of earning
revenue

When income statements are prepared, management or its accountants

extract revenues from internal records, sales, and other income totals. The
revenue-recognition principle provides that revenue is recognized when:
1. The earning process is complete or virtually complete.
2. An exchange transaction has taken place.
Revenue is usually recognized at the point of sale or transfer of rights to
the goods from the seller to the buyer, i.e., at the time of shipping.
Expenses are subtracted from revenues to arrive at net income or loss for
the period. An accounting principle called the matching concept gives guid-
ance on how expenses are to be recognized. The matching concept compares
incurred costs and expenses of a specific accounting period against revenue
earned during the same period in order to determine net income earned for
that period. This does not mean that an exact matching must occur. Some-
times this precision may be difficult to achieve. Matching means that the pe-
riodically recognized revenues presented in the income statement are
properly matched with the identified expenses for the same period.
An illustration of the matching concept is the handling of the cost of ma-
chinery acquired by a company. Ordinarily, a machine provides benefits to a
company for more than the period in which it was purchased. Under the
matching concept, an apportioning of the cost over the periods benefited is
essential for the correct calculation of income. A proper allocation of the cost
to these periods could be achieved by taking the cost of the asset, reduced by
any estimated scrap or residual value, and then dividing it by the number of
accounting periods served. This allocation of asset cost is called straight-line
depreciation. Exhibit 2–2 shows a comparative example income statement
with net incomes of $78,186 and $117,037 for the years 20X1 and 20X2, re-
spectively. It also shows the key components of the income statements as:
• Sales
• Cost of goods sold
• Operating expenses
• Other income (other expenses)
• Net income (loss)
Sales
The sales figure on the income statement represents the total of invoices billed
to customers during the period covered by the income statement. Therefore,
the sales figure usually represents both cash and credit sales. Often, the sales
figure represents net sales. Net sales are defined as the total of invoices billed
to customers during the period, less sales discounts and returns and allowances.
The net sales formula is:
Gross Sales – Sales Discounts – Sales Returns and Allowances
Sales discounts are granted to customers who pay bills early. Sales returns
represent merchandise that was sold and then returned by the customer. Sales
allowances are discounts granted to the customer because the product was
defective or not up to the quality level expected by the customer.

xhibit 2–2
Example Statement of Income for the 12 Months Ended December 31
20X1 20X2
Sales $8,173,780 $7,341,704
Cost of Goods Sold 5,963,510 5,189,315
Gross Profit 2,210,270 2,152,389
Operating Expenses:
Selling and Administrative Expenses 1,994,054 1,887,420
Depreciation 67,933 66,575
Interest 13,026 29,966
Total Operating Expenses 2,075,013 1,983,961
Profit from Operations 135,257 168,428

Other Income 6,429 35,609
Earnings Before Taxes 141,686 204,037
Provision for Income Taxes 63,500 87,000
Net Income $ 78,186 $ 117,037
5. During 20X1, a company had gross sales of $10 million. Of that $10 million in sales, 60
percent were cash sales that were granted a 5 percent discount. In addition, $250,000 of
merchandise that was sold was returned to the company for various reasons, and another
$100,000 of allowances were granted to customers after the sale, because the merchandise
was found to be defective. What are the corporation’s net sales for 20X1?
Cost of Goods Sold

The cost of goods sold is composed of those expenses incurred to manufacture
or purchase merchandise that has been sold. The cost of goods sold takes into
account material costs as well as labor and factory expenses. Often a separate
report, such as the one shown in Exhibit 2–3, called the cost of goods sold, is
prepared. The cost of goods sold report shows how the cost of goods sold ex-
pense, shown on the income statement, was computed. Sometimes, the cost
of goods sold calculation is included on the income statement; in that case, a
cost of goods sold report separate from the income statement is not necessary.
The cost of goods sold is found by using the following formula.

Beginning Inventory + Purchases and Freight In

− Purchase Returns and Allowances and Discounts on Purchases
− Ending Inventory
By subtracting the cost of goods sold from sales, you derive gross profit.
Gross profit is a preliminary indication of profitability. Also called gross profit
on sales or gross margin, this profit is called gross because operating expenses
must be subtracted from it.

xhibit 2–3
Cost of Goods Sold Report
Cost of Goods Sold:

Beginning Inventory $1,000
Purchases $500
Freight In 100
Cost of Purchases 600

Less: Purchase Returns and Allowances 50
Discount on Purchases 25 75 525
Cost of Goods Available for Sale 1,525

Ending Inventory 500
Cost of Goods Sold $1,025
6. Using the following financial data, calculate the cost of goods sold and gross profit.
Net Sales $1,200,000
Purchases and Freight In $700,00
Purchase Returns and Allowances and Discounts $25,000
on Purchases
Ending Inventory $625,000

Operating Expenses
Operating expenses are the day-to-day expenses incurred in running a firm.
Falling into the category of operating expenses are:
• Selling and administrative expenses
• Depreciation
• Interest
If operating expenses are less than gross income, as is the case in Exhibit
2–2, then the result is a profit from operations. If the opposite is true, with
operating expenses greater than gross profit, then the result would be a loss
from operations.
Other Income (Other Expenses)

Revenues from sources other than the principal activity of the business are
called other income. This type of income is also called non-operating income.
Examples of other income include income from investments (such as dividend
or interest income), rent, and capital gains from the sale of plant assets. Ex-
penses that are not incurred in normal operations are called other expenses.
Examples of other expenses could include the loss incurred from the damages
caused by a hurricane.
Net Income (Loss)

The bottom-line figure on the income statement is net income (loss). Net in-
come increases owners’ equity, whereas net loss decreases owners’ equity. As
was mentioned in the balance sheet section earlier, only two things can happen
to net income:
1. It can be reinvested in the firm (retained earnings).
2. All or a portion of it can be paid out to the owners of the firm in the form
of dividends.
With the income statement completed, the statement of retained earnings
can be prepared. In fact, the income statement and statement of retained earn-
ings are often combined into one statement.
STATEMENT OF RETAINED EARNINGS

This statement details the changes in the retained earnings accounts for the
same period as the income statement. The statement consists of the beginning
balance of retained earnings, the net income (loss), any dividends paid out,
and the ending balance of retained earnings. The example statement of re-
tained earnings shown in Exhibit 2–4 is based on the information given in the
financial statements shown in Exhibits 2–1 and 2–2. The formula for the state-
ment of retained earnings is as follows:
Beginning Retained Earnings + Net Income – Dividends
= Ending Retained Earnings

xhibit 2–4
Example Statement of Retained Earnings for the 12 Months Ended Dec. 31
20X1
Retained Earnings, Beginning $ 992,398

Net Income 78,186
Retained Earnings, Ending $1,070,584
7. Match the items shown below with the financial statement on which they appear. Use the
letters IS for the income statement, SRE for the statement of retained earnings, or BOTH, if
the account appears on both the statement of retained earnings and the income statement.
a. ____ Net income
b. ____ Dividends
c. ____ Beginning retained earnings
d. ____ Net sales
e. ____ Ending retained earnings
8. Match the following accounts with the statement where they appear. Use the letters BS to
signify balance sheet, IS for income statement, and SRE for statement of retained earnings.
a. ____ Dividends paid by the corporation to stockholders
b. ____ Current liabilities
c. ____ Cost of goods sold
d. ____ Additional paid-in capital
e. ____ Mortgage payable
f. ____ Net sales
g. ____ Sales returns and allowances
h. ____ Other income
i. ____ Long-term investments
j. ____ Selling and administrative expenses
9. Assume a company had beginning retained earnings of $100,000. Calculate ending retained
earnings under each of the following independent scenarios.
a. Net income of $50,000, dividend of $20,000
Ending Retained Earnings $________
b. Net loss of $30,000, dividend of $20,000
c. Break-even (no net income or net loss), dividend of $70,000
d. Net income of $30,000, no dividends declared or paid

STATEMENT OF CASH FLOWS

The statement of cash flows originated as a management tool. Its purpose was
to show where the cash came from and where it went during a particular pe-
riod. In 1987, the FASB made the statement of cash flows mandatory with
Opinion No. 95. What this means is that the statement of cash flows became
a required part of the basic set of financial statements.
The statement of cash flows provides the user with a detailed summary
of all the cash provided during the period and the uses to which the cash was
put. It is extremely important because it reflects the operating, financing, and
investment activities of an organization. The statement is useful for managers
in evaluating past financing and investing activities and in planning future fi-
nancing and investing activities. The statement is also useful to creditors and
investors in their analysis of a firm’s financial condition. Chapter 6 discusses
this important statement in greater detail. Exhibit 2–5 presents one of the two
alternative formats for this report: the indirect method.
NOTES TO THE FINANCIAL STATEMENTS

AND SUPPLEMENTAL INFORMATION
Notes to the financial statements are a very important source of information
for the analyst. Notes provide additional information about a company’s oper-
ations and financial position and are considered an integral part of the financial
statements. They can amplify or explain information in the financial statements
or add supplemental information that might be of interest to decision-makers
who will read the statements.
The full-disclosure principle requires that information that could influ-

ence a financial statement reader’s judgment must be disclosed in the financial
statements. Since some variables cannot be reflected in the numbers, they can
be disclosed in the notes. Many contingent liabilities and material events sub-
sequent to the balance sheet date are disclosed in the notes to the financial
statements. In addition, details on accounting policies, debt, future commit-
ments, other material transactions including those with related parties (such
as transactions between a parent company and its subsidiaries or transactions
between management and principal owners), as well as many nonfinancial
events that may affect future operations should be presented in the notes.
Notes to financial statements cover such issues as:
• Significant accounting policies and practices—The accounting policies that
are most important to the portrayal of the company’s financial condition
and results must be disclosed in the notes to the financial statements.
• Income taxes—Detailed information about the company’s current and de-
ferred income taxes. The information is broken down by level—federal,
state, local, and/or foreign.
• Pension plans and other retirement programs—The notes contain specific
information about the assets and costs of these programs, and indicate
whether and by how much the plans are over- or under-funded.

• Stock options—Stock options granted to officers and employees, including

the method of accounting for stock-based compensation and the effect of
the method on reported results.
• Property, plant, and equipment holdings
• Maturity patterns of bond issues
• Significant uncertainties—i.e., any pending litigation
• Details of capital stock issues
xhibit 2–5
Example Statement of Cash Flows (Indirect Method)
Cash Flows from Operating Activities:

Net Income per Income Statement $ 78,186
Add:
Depreciation $ 67,933
Decrease in Other Assets 2,000
Increase in Accounts Payable 106,627 176,560
Deduct:
Increase in Accounts Receivable 23,197
Increase in Inventories 35,570
Increase in Prepaid Expenses 2,247
Decrease in Accrued Expenses 933
Decrease in Accrued Income Taxes 5,321 67,268
Net Cash Flow from Operating Activities $187,478
Cash Flows from Investing Activities:

Purchase of Marketable Securities $ 66,006
Cash Paid for Equipment 59,290
Net Cash Flow Used for Investing Activities ($125,296)
Cash Flows from Financing Activities:

Cash Paid to Retire Debt 27,670
Cash Paid to Purchase Treasury Stock 22,500
Net Cash Flow Used for Financing Activities ($ 50,170)
Increase in Cash $ 12,012

Cash at the Beginning of the Year 37,988
Cash at the End of the Year $ 50,000

Financial statement users need to understand all the significant risks of

an entity, and therefore disclosures should be made as of the balance sheet
date about items and events that could significantly affect the reported
amounts in the near term (within one year). Possible significant risks related
to products, markets, locations, and the industry within which the business is
operating should be revealed through supplemental notes.
Analysis of financial statements is not complete until the notes to the fi-
nancial statements are read and analyzed for any transactions or information
that will affect the future operations of the enterprise. Notes help give the
complete picture.
MANAGEMENT’S DISCUSSION AND

ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The Management Discussion and Analysis (MD&A) is a section of a com-
pany’s annual report in which management discusses numerous aspects of the
company, both past and present. The MD&A provides an overview of the pre-
vious year of operations. Management will also write about the upcoming
year, outlining future goals and approaches to new projects. The MD&A is a
very important section of an annual report, especially for those analyzing the
fundamentals of a company. It contains useful information. However, investors
should keep in mind that the section is unaudited.
The content in a MD&A can include a discussion of the business envi-
ronment and risks that the company operates within, segment-wise perform-
ance, liquidity and capital sources, environmental matters (potential liabilities
related to environmental obligations), market risk, inflation and other uncer-
tainties, and critical accounting estimates.
This chapter introduced the four financial statements: the bal-

ance sheet, the income statement, the statement of retained
earnings, and the statement of cash flows. The financial state-
ment user must understand the components of each of these
statements. Each section of a financial statement reports
something unique, and classifications (current versus long-
term) within the balance sheet help users analyze such issues
as liquidity and debt burden.
The balance sheet is the line-by-line version of the basic accounting
equation:
Assets = Liabilities + Owners’ Equity
The income statement shows revenues earned during a period of time,

the expenses incurred to produce that revenue, and the income or loss for that

period. The statement of retained earnings details the changes in the retained
earnings accounts for the same period as the income statement. The statement
consists of the beginning balance of retained earnings, the net income (loss),
any dividends paid out, and the ending balance of retained earnings. The for-
mula for the statement of retained earnings is as follows:
Beginning Retained Earnings + Net Income − Dividends
= Ending Retained Earnings
The statement of cash flows was also introduced in this chapter with an
example of the statement prepared under the indirect method. The statement
can also be prepared using the direct method, but the mechanics of that
method are beyond the scope of this course. The statement of cash flows shows
the sources and uses of cash during the period covered by the financial state-
ments. It is an important financial statement since it is the only one prepared
on a cash basis (under GAAP rules), and since a company’s obligations are al-
most exclusively settled with cash, the statement of cash flows is of great in-
terest to investors and creditors.
The notes to the financial statements are important sources of informa-
tion for analysts. Accounting procedures, accounting policies, estimates and
significant near-term risks should be disclosed by management as supplemen-
tary notes that need to be read and analyzed by statement users to get the
whole picture.

Review Questions
1. If total assets are $1,000,000, total liabilities are $300,000, capital 1. (b)
stock totals $100,000, and there are no other equity accounts other
than retained earnings, what is the retained earnings balance?
(a) $700,000
(b) $600,000
(c) $500,000
(d) $400,000
2. ABC Corporation buys $35,000 of merchandise inventory from 2. (b)

XYZ Company and will pay for the inventory in one month.
Which of the following statements is true about the nature of
that transaction?
(a) Assets (inventory) are increased by $35,000 and notes payable
(a liability) is increased by the same amount.
(b) Assets (inventory) are increased by $35,000 and accounts payable
(a liability) is increased by the same amount.
(c) Cost of goods sold (an expense) is recognized.
(d) The transaction has no impact on the financial statements.
3. All of the following increase equity except: 3. (c)

(a) Purchase of common stock by investors who purchase it directly
from the company as a first time issuance.
(b) Net income greater than dividends for the period.
(c) The acquisition of treasury stock by the corporation that initially
issued the stock (acquiring its own stock).
(d) Initial public offering of preferred stock (a type of capital stock.)
4. A company issues 10,000 shares of $20 par value stock and raises a 4. (a)
total of $300,000 of capital. How much is the additional paid-in
capital as a result of this transaction?
(a) $100,000
(b) $200,000
(c) $300,000
(d) $400,000

5. A company sells one product—a wrist watch with a colorful silicon 5. (d)
band. The watch has a list price of $25. For an entire year the product
is on sale at 20% off and the company sold 10,000 units (watches), all
on credit. About 40% of the customers paid their bills early to take
advantage of a 5% discount for early payment, while watches with a
sales value of $12,000 were returned by customers for various reasons.
Which of the following is an estimate of net sales?
(a) $250,000
(b) $233,000
(c) $200,000
(d) $184,000
ANSWERS TO “THINK ABOUT IT…”

1. A. LTI
B. PPE
C. LTI
D. CA
E. CA
F. PPE
G. PPE
H. LTI
I. CA
J. LTI
2. A. CL
B. CL
C. LTL
D. LTL
E. CL
3. Common stock $100,000

Additional paid-in capital 250,000
Less: Treasury stock (70,000)
Retained earnings 55,000
Total equity $335,000
4. A. 2
B. 1
C. 4
D. 3
E. 3

5. Gross Sales $10,000,000

Sales Discounts (300,000)
Sales Returns and Allowances (350,000)
6. Cost of Goods Sold

Add: Purchases and Freight In 700,000
Less: Purchase Returns and Allowances
and Discounts on Purchases 25,000
Less: Ending Inventory 625,000
Cost of Goods Sold $650,000
Gross Profit:
Less: Cost of Goods Sold 650,000
Gross Profit $550,000
7. A. BOTH
B. SRE
C. SRE
D. IS
E. SRE
8. A. SRE
B. BS
C. IS
D. BS
E. BS
F. IS
G. IS
H. IS
I. BS
J. IS
9. a. $130,000
b. $50,000
c. $30,000
d. $130,000

The Balance Sheet: Assets
3
Learning Objectives
to:
• Identify the components of each asset group.
• Identify the valuation methods for each asset
group.
INTRODUCTION
An asset is a probable future economic benefit obtained or controlled by a
particular entity as a result of past transactions or events (FASB, 1980). A sim-
plified definition of an asset would be: a thing of value, physical or otherwise, that
will probably give future economic value to the entity. Future may be taken to mean
any time from now until the end of the entity’s existence. Assets are subdivided
into four major categories:
1. Current assets
2. Long-term investments
3. Property, plant, and equipment, including fixed assets (tangible and intan-
gible) and wasting assets (natural resources)
4. Other assets
41
CURRENT ASSETS
Current assets are those that will most likely be converted into cash, sold, or
consumed within a period of one year. Under the general classification of as-
sets, current assets are the first subcategory and appear in the order of their
liquidity, with the most liquid of the current assets listed first. The list of cur-
rent assets includes:
• Cash
• Marketable securities
• Receivables
• Inventories
• Prepaid expenses
Cash
On the balance sheet, current assets appear in order of their liquidity. The
most liquid of these, cash, is listed first, followed by the less-liquid assets. Be-
sides currency and coin, cash includes personal checks, bank drafts, money
orders, cashier’s checks, and money on deposit in banks.
Marketable Securities
Marketable securities, otherwise called short-term investments, involve the
temporary use of excess cash in order to earn interest or dividends until the
cash is needed.
Short-term investments are the closest thing to cash on the balance sheet.
They are reported in three possible categories according to generally accepted
accounting principles: trading securities, available-for-sale securities, and
held-to-maturity securities.
Trading securities are marketable securities that are to be held for a short
time and sold for more than their cost. In other words, the intent of manage-
ment is to sell trading securities soon at a gain. Therefore, trading securities
are always reported in the current asset section of the balance sheet. Trading
securities are typically in the form of equity (stock) or debt (bonds or notes).
For example, ABC Corporation could own shares of Apple Inc. as a way of
utilizing its cash effectively (hoping for dividends and capital gains to provide
a good yield on the investment).
Trading securities are recorded at cost (what the firm pays for the in-
vestment), and any income (dividends or interest) is recognized as incurred.
In a departure from the cost principle, the value of trading securities on the
balance sheet can be increased if the fair market value of the investment rises
above its cost. That is called an unrealized gain (it is unrealized because the
investment has not been sold.)
The accounting for fair market value of trading securities is beyond the
scope of this course; however, understanding that marketable securities are
subject to price fluctuations (unrealized gains and unrealized losses) gives the
financial statement user additional insight into how to read and interpret in-
formation related to current assets and liquidity.

THE BALANCE SHEET: ASSETS 43
Held-to-maturity and available-for-sale securities can also be classified

as current assets. They can be shown as part of short-term investments, de-
pending on if they are readily converted to cash and if it is management’s in-
tent and ability to hold them until they mature. Held-to-maturity securities
are debt instruments (bonds) that management intends to hold until they ma-
ture. If the maturity date is beyond one year, the investment is classified on
the balance sheet as a long-term investment. If the held-to-maturity invest-
ments will mature within the year, they are classified as a current asset. Held-
to-maturity investments are listed at what is called the amortized cost, a
method that takes into account any discounts or premiums paid when the
bond was purchased.
Available-for-sale securities may be debt investments (bonds) that man-
agement does not intend to hold until maturity or equity (stock not classified
as trading securities.) Under GAAP rules, if the company owns less than 20%
of the issuer of equity available-for-sale securities, then those securities are
shown at their fair market values on the balance sheet. This means that their
value is most likely derived from quoted prices (stock market or bond market)
and therefore is subject to fluctuations similar to those described with trading
securities. If the company owns more than 20% of the issuer of equity secu-
rities, a method of valuation called the equity method is used. There is more
on the equity method in a subsequent section of this chapter. Available-for-
sale securities are considered long-term investments.
Receivables
There are three main categories of receivables:
1. Amounts due from customers for sales made or services rendered on ac-
count, commonly called trade receivables or accounts receivable
2. Promissory notes, commonly called notes receivable
3. Accruals due for such items as rents and interests, or obligations due from
employees, etc., commonly called other receivables
Receivables are valued at the amount due from the entity owing the debt.
Often a provision for losses is made and set up in a contra-asset account called
“allowance for doubtful accounts.” A contra-asset account’s balance is sub-
tracted from an associated account on the balance sheet. In the case of a re-
serve for bad debts, the allowance for doubtful accounts balance, which is an
estimate of the dollar amount of receivables that will become uncollectible,
is subtracted from the receivables value on the balance sheet to derive the
book value of receivables. For example, if the total amount owed from cus-
tomers is $1,000,000, and it is estimated that of that $1,000,000, $50,000 will
not be collected, then the book value of receivables would be $950,000. Con-
tra-asset accounts are further discussed later in this chapter since they are
used to compute the book value of various other assets.
Receivables can also be written off; a process that removes the receivables
balance from the balance sheet. When it is determined that an amount owed
from a specific customer will not be collected, as is often the case when the
customer is bankrupt or is deceased with few or no net assets remaining in

the estate, the account is written off (often called a write-off). A write-off si-
multaneously reduces the asset value of the receivable and the balance of the
allowance for doubtful accounts.
Inventories
Inventory is acquired for resale or used to produce goods that will eventually
be sold. Retailing firms have one inventory account called merchandise. Man-
ufacturing firms usually have three inventory accounts:
1. Raw materials
2. Work in process
3. Finished goods
Inventories are recorded at the lower of market or cost. The market value
is also referred to as net realizable value. The accounting profession has devel-
oped guidelines for determining this value. The net realizable value is the
amount that is expected to be realized on the eventual sale of the inventory,
plus a normal profit margin. Costs to be included in inventory include:
• Purchase price of inventory, or in the case of manufacturing, the cost of
the materials, labor, and overhead factored into the final cost of the finished
product
• Costs to bring the inventory items to the concern’s location, such as freight
charges
• Direct labor and manufacturing overhead incurred in preparing the raw
materials for final sale (these costs would, of course, not exist for a retail-
type operation)
• Manufacturing overhead, including such costs as indirect material, indirect
labor, depreciation, taxes, utilities, and insurance
Once the total cost has been assigned to inventory, the final step is to de-
cide on the cost-flow assumption to be used in valuing the inventory. The
most common methods of valuation are:
1. Specific identification
2. Average cost
3. First in, first out (FIFO)
4. Last in, first out (LIFO)
Specific Identification
This method requires that each unit on hand be specifically identified. Spe-
cific identification is usually only cost effective in situations of high-value in-
ventory, such as those involving automobiles or jewelry. Specific identification
is either impossible or not cost effective in situations where inventory consists
of low-value items.
Average Cost
This method uses the simple average cost of all purchases to value the inven-
tory. A weighted average or a moving average may also be used. Since the

average-cost method is relatively simple and easy to apply, it is popular. As

its name implies, the cost here is determined by dividing the total cost by the
total units purchased to arrive at an average cost per unit. This average cost
is then multiplied by the units on hand to arrive at an inventory value. This
method works well with products that are largely homogeneous and, in times
of stable prices, tends to give a good approximation of the replacement value
of inventory and an accurate cost of goods sold.
First In, First Out (FIFO)

The FIFO method assumes that the first items into the business are the first
items sold. The cost of the inventory is valued as the sum of the costs of the
most recent purchases. In most situations, especially retail environments, this
method probably closely approximates the true cost of the inventory on hand
since it matches typical inventory flow. With the FIFO method, inventory
value is often close to a replacement cost because the value is of the most re-
cent purchases. In times of rapidly rising prices, however, income is maxi-
mized, as older costs (the first items purchased) would be matched to newer
revenues.
Last In, First Out (LIFO)

The LIFO method makes an assumption that is the exact opposite of FIFO.
LIFO assumes that the costs of the most recently acquired goods are allocated
to the latest sales and that the costs of the earliest units purchased are allocated
to inventory. When LIFO is used in times of sharply rising prices, net income
is minimized because the higher recent costs are used to compute the cost of
goods sold and are matched against the most recent sales.
The valuation methods mentioned above are the most commonly used.
These discussions are brief and merely scratch the surface of the study of in-
ventory. A financial analyst needs to be aware of the valuation method used
by the company under examination in order to determine whether the value
of the inventory is materially correct and how closely it reflects the true value
of the inventory. The method of valuation is usually in the form of disclosed
notes to the financial statements.
1. Identify the inventory valuation method that would yield the following results in an environment
of rising prices:
___ Highest net income
___ Greatest ending inventory value
___ Lowest income tax liability

2. Identify the inventory valuation method that would yield the following results in an environment
of falling prices:
___ Highest net income
___ Greatest ending inventory value
___ Lowest income tax liability
3. Why are short-term (trading securities) marketable securities carried on the balance sheet at
fair market value?
Prepaid Expenses
A prepaid expense is an expenditure that will benefit a future period. Exam-
ples are: prepaid rent, taxes, royalties, commission, prepaid office supplies,
and insurance. Prepaid items are allocated to a future period based on a meas-
urable benefit, use, or a time or period cost. For example, if a lease were pre-
paid for a year, each month would expense one-twelfth of the prepaid amount.
LONG-TERM INVESTMENTS
Long-term investments include such assets as:
• Stocks and bonds
• Land held for future use or speculative purposes
• The cash surrender value of life insurance policies
• Investments set aside in special funds, such as pension or plant-expansion
funds
• Investment in other companies
• Loans made to other companies
• Real estate unrelated to ordinary operations of the business
• Joint ventures with other entities that will be carried on for more than one
year

Each of these investments may be evaluated in terms of the rate of return

it generates. The size of the return depends on numerous variables. Some of
the variables that should be analyzed, if possible, are:
1. The marketability of the asset
2. The availability of the asset, if the company wishes to use it as collateral
for loans, either short or long term
3. The current fair market value of the asset
4. The profitability of investment in subsidiaries
Special attention must be paid to valuation of long-term investments.

The methods of valuation used for long-term investments depend on the type
of investment.
Cost Method of Valuation

When the investment is in nonequity securities, it is recorded and reported
at cost. It remains at the original cost until such time as it is wholly or partially
disposed of, some verifiable permanent change causes the value of the asset
to drop, or a liquidating dividend is received.
The historical cost of an investment consists of the costs of acquiring it,
including commissions to brokers, taxes, and other transaction costs. The his-
torical cost principle restricts the write-up of investments to their market
value, which can sometimes result in an undervalued balance sheet. The fi-
nancial analyst must know about this restriction and interpret the information
on the balance sheet accordingly.
Some companies address the undervaluation of investments by disclosing
their market value, as of the statement date, as a supplementary schedule or
in a footnote.
Equity Method of Valuation

When an investment exceeds 20% of the ownership in another company (but
less than 50%), the equity method of valuation is used.
The equity method of accounting for long-term investments records the
acquisition cost as of the date of purchase. This figure is adjusted according
to the investor’s proportionate share of the company’s earnings or losses after
the date of acquisition. The offset is reflected as recognized earnings or losses
in income. Dividends received reduce the carrying value of the investment
account.
If an investment in another company exceeds 50% ownership interest,
the “parent company” prepares consolidated financial statements. Consoli-
dation is a topic that is beyond the scope of this course, but in summary, con-
solidated statements are combined financial statements of a parent company
and its subsidiaries. There are accounting rules on how consolidation is to be
done but in essence those rules attempt to give a financial picture of an entity
so that users can gauge the overall health of an entire group of companies.

Answers appear at the end of the chapter.
4. ABC Corporation purchased 500,000 shares of XYZ’s common stock at $30 per share. XYZ
had 2,000,000 shares of common stock issued and outstanding. Net income for the most recent
year ending December 31, 20X1 was $3,000,000 and there was a dividend declared during the
year of $.50 per share.
Calculate the following:
a. The amount at which ABC will list the stock of XYZ on the balance sheet upon its
acquisition $___________
b. ABC’s share of XYZ’s net income for the year $__________
c. The balance for ABC’s investment in XYZ as reported on the

December 31, 20X1 $________
PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment (fixed assets), the third category of assets, are
used in the operation of the business and have a useful life of more than one
year. They may be broken down further into:
1. Tangible fixed assets
2. Intangible fixed assets
3. Wasting assets (natural resources)
Included in property, plant, and equipment are assets that businesses use
to produce and distribute goods and services. For example, land, buildings,
machinery, equipment, furniture, fixtures, automobiles, and trucks are tangible
fixed assets. Notice how the assets noted above meet the definition of fixed
assets. These assets are not intended for resale and are not readily convertible
into cash. Their expected useful life is more than one year. The expense recog-
nition of fixed assets, with the exception of land, is recognized through peri-
odic, systematic write-offs to the company’s income, called depreciation.
Tangible Fixed Assets

Tangible assets have a physical existence and include such items as land,
buildings, equipment, machinery, furniture, fixtures, and carpeting. These as-
sets fall into groupings of either real property or personal property. When a
tangible asset is not used in the firm’s ongoing operations, it is not classified
as property, plant, and equipment but is under a separate heading such as
other assets. Historical cost is the basis normally used for recording the ac-
quisition of tangible assets. Historical cost is the price paid for the asset on

the date of acquisition, plus other costs, such as freight, installation, and setup.
With the exception of land, the historical cost of most tangible fixed assets is
recognized (using a method of depreciation) as an expense over the useful life
of the asset. Depreciation occurs when an asset loses its utility (usefulness).
Regardless of the money spent for repairs and maintenance, eventually the
time comes when all property, plant, and equipment can no longer favorably
contribute to business activities and must therefore be retired.
Accounting for depreciation is a process of cost allocation and not valu-
ation. Depreciation is a way of allocating the cost of a tangible asset in a sys-
tematic and rational way over the useful life of the asset. Here’s how the
AICPA has defined depreciation:
A system of accounting which aims to distribute the cost of other

basic values of tangible capital assets, less salvage (if any), over the
estimated useful life of the unit (which may be a group of assets) in
a systematic and rational manner. It is a process of allocation, not of
valuation. Depreciation for the year is the portion of the total charge
under such a system that is allocated to the year. Although the allo-
cation may properly take into account occurrences during the year,
it is not intended to be a measurement of the effect of all such oc-
currences (AICPA, 1961).
Although depreciation represents a business expense and is therefore re-

flected on the income statement, depreciation also affects the balance sheet.
A balance sheet account, called accumulated depreciation, is used to accumulate
the depreciation expense that is recognized on fixed assets. Accumulated de-
preciation is a contra-asset account. As was mentioned in the discussion of
receivables, a contra-asset account’s balance is subtracted from an associated
account on the balance sheet. In the case of fixed assets, the balance of accu-
mulated depreciation is subtracted from the cost of fixed assets to derive the
net fixed asset (net book value). In Exhibit 3–1, the book value of the building
is shown at $52,000.
A common depreciation method is straight-line depreciation, where the
cost of the asset less any predicted residual value (the estimated value at the
end of the useful life) is divided by the number of years of useful life. Other
methods of depreciation are allowed, including those that recognize a variable
amount of depreciation based on use (units of production) and accelerated
methods that produce larger depreciation expense in early years and smaller
amounts in later years (when compared to straight-line).
Appreciation of a long-lived, tangible asset constitutes an increase in the
current value of property; in other words, the appreciation is the excess of the
present value of property over its book value. Appreciation should not be
viewed as the opposite of depreciation.
Depreciation is lost usefulness, whereas appreciation is not necessarily
an increase in usefulness but rather an increase in the current market value.
Increases in the value of assets are not recognized in the accounting records
until they become realized through sale or exchange. Land is never depreci-
ated because it ordinarily doesn’t lose its usefulness. Some companies show

xhibit 3–1
Appreciation
Building (Current Appraised Value, December 31,1991: $127,000)
At Cost $83,000
Less: Accumulated Depreciation 31,000
$52,000
!
the appreciated value parenthetically in the balance, as is the case in Exhibit

3–1, where the building has a historical cost of $83,000, a book value of
$52,000, and a current value of $127,000.
The current, or appreciated, value can be included in the footnotes to
the financial statements instead of including it in the property, plant, and
equipment section of the balance sheet, and reliable, independent appraisers
should determine the new values.
5. Explain why this statement is false: “Depreciation recognizes that the market value of a long-
term asset has fallen due to wear and tear and obsolescence.”
6. Machinery was bought at the beginning of year 1 for a purchase price of $50,000 plus $10,000
installation charges. The machinery is depreciated over a useful life of 10 years (straight-line
depreciation, which means an equal amount of depreciation each year). If you assume no resid-
ual (terminal value) of the equipment, what would be the net book value after the third year?
Cost $_____ less Accumulated Depreciation $_____ = Net Book Value _____
Intangible Assets
Intangible assets are those that have no physical existence. Their value de-
pends on the rights and benefits enjoyed by the owner. Some of the more im-
portant intangible assets are:
• Patents, copyrights, and trademarks
• Leases and leaseholds
• Licenses and franchises
• Goodwill

Intangible assets are carried at their cost and, like tangible fixed assets,
should be a periodic write-off of the costs. The periodic recognition of the
cost of intangible assets is called amortization. The time period or useful life
of an intangible asset is dependent upon the expected years of usefulness to
the acquiring company, or the useful life may be dictated by government reg-
ulations. The next several paragraphs describe some of the typical intangible
assets found on company balance sheets.
Patents have a limited life span of 20 years granted by the federal gov-
ernment. A patent gives the holder exclusive rights to control the manufacture
and sale of the protected product. However, if the company feels that the
product will become obsolete or be superseded by another prior to the end
of its legal life, a shorter time period for amortization may be estimated.
Copyrights grant the holder control over “original works of authorship”
fixed in tangible form. The basic term of copyright for such works created
after January 1, 1978 (pursuant to the Copyright Act of 1976) is the life of the
author plus 70 years after his or her death. Like patents, the useful life of copy-
rights may be reduced from the 70 years.
Trademarks, which represent the right to exclusive use of a symbol or
name, are amortized over a period not to exceed 40 years. The registration of
a trademark may be renewed every 20 years for an unlimited period of time,
but the cost will not go beyond the amortization period.
A lease is a contract between two parties—a lessor and a lessee—that
grants the lessee exclusive use of some property for an extended period of
time. Also known as a leasehold, the most common type of lease calls for
monthly lease payments that are expensed as incurred. There is one situation
that may create an intangible asset, which occurs when there are prepaid lease
payments. This type of payment is usually classified as an intangible asset.
Licenses and franchises award rights to be operative for a specified time
period that is negotiable between the company and the issuing agent. A fran-
chise grants the right to an exclusive territory or market, whereas a license
gives its holder official or legal permission to do or own a specific thing. As
with other intangible assets, a license and franchise are recorded at cost, which
is spread over the life of the licence or franchise.
Goodwill results from such factors as good customer relations, efficiency
of operation, reputation for dependability, quality of products, location of op-
eration, and credit rating. It is recorded on the books when purchased in con-
nection with the acquisition of a business. It represents the potential of a
business to earn above-normal profits and may be referred to as the present
value of expected future earnings that are anticipated to be above normal.
Even though all of the factors listed above may be in existence, they cannot
be recorded under the heading of goodwill because there is no verifiable cost
basis. At one time, goodwill was amortized over a period of 40 years. That is
no longer the rule under GAAP (FASB 142). Now companies that carry good-
will on the balance sheet are required to determine the fair value of the re-
porting units, using present value of future cash flow, and compare it to their
carrying value (book value of assets plus goodwill minus liabilities.) If the fair
value is less than carrying value, the goodwill value is considered “impaired.”
Simply put, impairment means that goodwill’s value on the balance sheet

needs to be reduced. The specifics of goodwill impairment are beyond the

scope of this course, but it is another example of how some assets produce
losses. The impairment loss is reported as a separate line item on the income
statement, and new adjusted value of goodwill is reported in the balance sheet.
Intangibles carry with them a mark of uncertainty. Caution and clear un-
derstanding of the nature of these assets are required to correctly evaluate
their worth to a company. Some companies, in an attempt at conservatism,
follow the practice of writing their intangibles down to one dollar, which says
that intangibles exist but that there is uncertainty about their value.
Wasting Assets
The third group of fixed assets consists of wasting assets, or natural resources.
The chief difference between tangible and intangible fixed assets and wasting
assets is that the latter cannot be replaced easily. For example, lumber is a
wasting asset. It takes approximately 35 years for a new crop of trees to reach
the age of harvest.
A material amount of economic activity can be attributed to the discov-
ery, development, extraction, processing, and sale of these natural resources.
Natural resources are subject to exhaustion through extraction. Examples of
wasting assets are mineral deposits (coal, sulphur, iron, copper, and other types
of ore), oil and gas deposits, and standing timber. With the exception of timber,
which can be replenished by planned cutting and reseeding, other natural re-
sources become exhausted, losing most of their value.
Generally accepted accounting principles require that natural resources
be recorded at their original cost, plus costs incurred for discovery, explo-
ration, and development. Once the cost has been determined, the write-off
policy is established. Write-off of natural resources to income is called depletion
and is usually calculated on the basis of estimated units available for extrac-
tion. To illustrate, assume land containing natural resources was purchased
at a cost of $7.2 million (see Exhibit 3–2). After extraction and removal of the
resources, the land is reclaimed and has an estimated fair market value of
$600,000. Natural resources underground are set at 1.2 million tons. The cal-
culation for depletion per unit of extraction is shown in Exhibit 3–2.
xhibit 3–2
Depletion of Natural Resources
Building (Current Appraised Value, December 31,1991: $127,000)
At Cost $83,000
Less: Accumulated Depreciation 31,000
$52,000
!

Depletion cost per ton is $5.50. An accounting rule of thumb is that the
depletion cost per unit follows the unit after it is extracted. For example, when
a ton of resource is sold, the unit depletion cost becomes part of the cost of
goods sold. The extracted resources that remain unsold become an inventory
with a $5.50 per ton cost for depletion.
A financial analyst must be aware that, although write-off of natural re-
source cost is relatively easy to calculate, it is not necessarily precise. Numer-
ous complications may arise. For example, the original estimate of the number
of units of natural resource available may be erroneous. Because of these com-
plications, periodic adjustments should be made according to new information
received. In spite of these complications, though, the fact that estimates are
not precise does not mean that periodic depletion charges should be ignored.
7. Match the asset with the method used to allocate its cost:
A. Building ______
B. Land ______
C. Patent ______
D. Mineral deposits ______
E. Oil and gas reserves ______
F. Computers ______
G. Franchise rights ______
H. Accounts receivable ______
Cost-Allocation Methods:
1. Depreciation
2. Amortization
3. Depletion
4. Asset’s cost is not allocated under any method
OTHER ASSETS
This is a catch-all for assets that cannot be classified properly elsewhere. Ex-
amples of other assets include some long-term, prepaid expenses; refundable
deposits on term leases; and organization costs.

Assets are things of value that will probably give the company
some measurable future benefit. Assets are subdivided into
four major categories: current assets; long-term investments;
property, plant, and equipment; and other assets. Receivables,
inventory, and investments may need to be revalued periodi-
cally, as their fair market value can fluctuate based on a variety
of factors. Receivables can be written off because of noncol-
lection, and accounting rules also dictate that an allowance for
doubtful accounts (a contra-asset account) must be established to properly
reflect the book value of receivables. Inventory is reported at the lower of cost
or market value. Investments are shown at fair market value—as determined
by the price that would be received to sell the investment in a transaction be-
tween market participants. Investments can be classified as either short-term
or long-term depending on management’s intention and the nature of the in-
vestment.
Fixed assets such as such as buildings and equipment are recorded at cost
and that cost is allocated over periods of useful life by a process called depre-
ciation. In other words, a portion of the cost of all fixed assets (with the ex-
ception of land) is recognized as an expense (depreciation expense) over the
period of time that the asset will provide benefits to the firm.
Natural resources and some intangible long-term assets are also expensed
over a period of useful life by the processes of depletion (natural resources)
and amortization (intangible long-term assets).

Review Questions
1. Which of the following categories of assets is most likely be converted 1. (a)

to cash, sold, or consumed within one year?
(a) Current Assets
(b) Long-Term Investments
(c) Property, Plant, And Equipment [Fixed Assets (Tangible And
Intangible), Natural Resources (Wasting Assets)]
(d) Other Assets
2. Which of the following is not a category of investments under GAAP? 2. (a)

(a) Plant and equipment
(b) Trading securities
(c) Available-for-sale securities
(d) Held-to-maturity securities
3. Which of the following should be included in the cost of inventory 3. (c)

on the balance sheet?
(a) The projected cost of a salesperson’s commission
(b) Costs to bring the inventory items to the customer’s location
(c) Direct labor and direct manufacturing overhead incurred in
preparing the raw materials
(d) Direct labor and overhead of a retail operation
4. Which of the following is not a long-term intangible investment? 4. (a)

(a) Patents, copyrights, and trademarks
(b) Leases and leaseholds
(c) Accounts and notes receivable
(d) Goodwill
5. Natural resources and some intangible long-term assets are expensed 5. (d)
over a period of useful life by the processes of ___ (natural resources)
and ___ (intangible long-term assets).
(a) depreciation / amortization
(b) depreciation / depletion
(c) depletion / depreciation
(d) depletion / amortization


1. FIFO, FIFO, LIFO
2. LIFO, LIFO, FIFO
3. Short-term securities will be redeemed or sold at close to their fair market value.
Take the example of a bond that is close to its maturity (redemption) date. Since it
is close to the date when it will be worth its face value, the current fair market value
is the best indication of value. Short-term debt securities do not fluctuate greatly in
value. On the other hand, equity securities (which do not have a maturity date) are
subject to much greater price fluctuation, but even in those cases, if management’s
intention is to sell them within the next 12 months, current fair market value is the
best indication of value.
4. ABC’s share of XYZ’s common stock = 500,000 shares / 2,000,000 shares, which
equals 25%. Therefore the equity method is used.
a. ABC’s initial investment in XYZ’s common stock = 500,000 shares
x $30 = $15,000,000
b. Company ABC’s share of XYZ’s net income = $3,000,000
x 25% = $750,000
c. ABC’s share of XYZ’s dividend declared = $.50 per share
x 500,000 shares = $250,000
5. Depreciation has nothing to do with market value. An asset’s historical cost—not its
current market value—is depreciated. In fact, an asset can be depreciated to the
point where it has a substantial market value while its net book value (cost less
accumulated depreciation) is zero. Depreciation is not a valuation method. It is a
systematic way of allocating the tangible asset’s cost over its useful life. The estimate
of the useful life takes into account variables such as obsolescence and wear and tear,
all of which do impact an asset over time, but depreciation really has no bearing on
making the net book value (cost less accumulated depreciation) approximate the
fair market value of the asset.
6. The cost is $60,000 and the depreciation each year is $6,000 ($60,000 / 10 = $6,000).
Therefore, after 3 years the accumulated depreciation would be $18,000 and thus
the net book value would be $42,000 ($60,000 – $18,000)
7. A. 1
B. 4
C. 2
E. 3
F. 3
G. 1
H. 2
I. 4

The Balance Sheet:
4
Learning Objectives
to:
• Distinguish between current and long-term
liabilities.
• Identify various types of liabilities.
• Identify the various components of equity on
the balance sheet.
INTRODUCTION
The assets of a company are financed by liabilities and owners’ equity. In other
words, assets are acquired with funds generated via debts or with owners’ in-
vestment. Current liabilities provide some of the working capital necessary
to run a business day to day. Long-term liabilities and owners’ equity provide
the permanent base of asset financing. In the sections that follow, you will
learn more about the specific accounts that are classified under liabilities and
owners’ equity. Much of this chapter entails definitions of terms. Knowledge
of these terms forms a foundation for analysis of a company’s financial struc-
ture; eventually, these terms will come in handy when performing financial
analysis using ratios and other quantitative techniques.
LIABILITIES
Liabilities are obligations resulting from past transactions requiring payment
by conveyance of assets or the rendering of future services. Liability amounts
57
must be definite or reasonably estimated. Liabilities are usually classified

under the following major subheadings:
• Current liabilities
• Long-term liabilities
Current Liabilities
Current liabilities are debts that will be satisfied within one year or within
the operating cycle, whichever is longer. The source of payment of current
liabilities usually is derived from current assets. A typical scenario is that
goods or services are sold on credit, an accounts receivable is created, cash is
collected from customers, and that cash is used to meet payments on the cur-
rent liabilities. Some typical current liabilities include:
• Accounts payable
• Notes payable
• Current maturities of long-term debt
• Cash dividends
• Accrued liabilities
• Revenues collected in advance
• Taxes payable
• Income taxes payable
• Guarantee and warranty costs
• Deferred income taxes
Accounts Payable
Accounts payable are obligations that arise from the purchase of stock-in-
trade items, supplies, or services on open account. These may also be called
trade accounts payable in order to differentiate them from amounts payable to
partners, officers, stockholders, employees, or affiliated companies, which
should be shown separately on the balance sheet. Rarely is interest charged
on accounts payable, and they are a more informal arrangement than a notes
payable, the topic of the next section.
Notes Payable
A note payable is a written promise signed by the maker of the note to pay a
certain sum of money, either on demand or at a future date. The negotiable
instrument (the note) may or may not bear a rate of interest although most
notes payables are evidenced by a promissory note that calls for interest. It
may be a trade note to suppliers of stock-in-trade items or services, or a short-
term loan note payable to financial institutions or other lenders. The advan-
tage to the holder of a note is that it is a written formal contract.
Current Maturities of Long-Term Debt

The portion of bonds, notes payable, and other long-term debts that mature
or are payable within the next fiscal year are reported as current liabilities,
with the balance shown as long-term debt.

THE BALANCE SHEET: LIABILITIES AND OWNERS’ EQUITY 59
Cash Dividends Payable

Unpaid cash dividends that have been declared by the board of directors but
not paid as of the financial statement date are called dividends payable. Divi-
dends do not accrue; the liability materializes only upon declaration by the
board of directors.
Accrued Liabilities
Also known as accrued expenses, these represent expenses, such as wages, interest
on note obligations, property taxes, and rent that accrue (or accumulate) on
a daily basis. As a result, the amount of the specific accrual must be deter-
mined as of the end of the accounting period and is listed in the liability sec-
tion of the balance sheet. If the amount cannot be determined exactly, a
reasonable estimate must be made when the financial statements are prepared.
Not only is this estimate necessary for proper presentation of the liability, it
also generates a charge to an expense account that must be recorded and used
in arriving at an income figure to properly match expenses to revenues.
Unearned Revenue
Any revenues collected before a service is actually performed must be shown
as liabilities. This type of liability is often called revenues collected in advance.
When the revenue becomes earned (as a result of performing a service or de-
livering a product), the unearned revenue account is reduced.
Taxes Payable
Sales taxes and employer portions of payroll taxes, such as social security, in-
come taxes withheld, and other payroll deductions, are examples of taxes col-
lected that will be remitted to a third party—such as a state department of
revenue and the IRS—sometime in the future. Income taxes payable, which
is a liability that results from the company’s earnings, are shown in a different
account, called income taxes payable.
Income Taxes Payable

Corporations are income-tax-paying entities. As the accounting period pro-
gresses, a provision for estimated income taxes is made and the expense is ac-
crued. The balance in the income taxes payable account represents these
accruals, less payments made to the IRS. The IRS requires that corporations
pay estimated taxes at various times during the year.
Due to the differences between taxable income as computed under tax
laws and accounting income computed under generally accepted accounting
principles, there arises the potential for differences between the reported in-
come on the financial statements and taxable income on the tax return. These
interperiod income tax allocations are reported on the income statement as
deferred income taxes payable as well as in the notes to the financial state-
ments.
Guarantee and Warranty Costs

A warranty is a commitment by a seller to make good on deficiencies in a
product. It entails future costs that could be material but are indefinite in

terms of amount, payee, or due date. (The costs of guarantees and warranties
should, however, be recognized if they can be reasonably estimated.)
These charges represent an estimate of all costs expected to result from
products sold with warranties and guarantees, and are recognized in accor-
dance with the matching principle.
There are two methods of recording these costs. The first is the cash basis,
in which warranties are charged to current operations as incurred. The cash
method is not an acceptable method under generally accepted accounting prin-
ciples. The second is the accrual method, where an estimated amount is charged
to current operations. For example, a company may sell 500 units and estimate
that each unit will incur $100 in warranty costs. The company would charge
an expense account for $50,000 and record a liability for $50,000. This liability
is usually current, unless there are long-term, extended warranties.
1. Match the description of each of the following obligations of a company to the liability
account name.
Obligation description Liabilities
1. ____ $1,500 of interest has A. Accounts Payable

accumulated in the truck loan account
as of the balance sheet of 12/31/20X1
date and will be paid on January 15, B. Notes Payable
20X2.
2. ____ Supplier of a manufacturer is C. Current Maturity of Long-term Debt

owed $10,000 for raw materials
purchased. The amount is due in
30 days. D. Accrued Liability
3. ____ $1,000 of rent is due from last

month’s use of an office.
4. ____ Electric bill from last month’s

electricity usage is due in 20 days.
5. ____ 12 payments ($2,200 each) are

due this year on a 30-year mortgage
that has about 10 years remaining. The
12 payments represent $21,500 of
principal that is shown on the balance
sheet as a current liability.


2. During 20X1, a company sells 1,000 units that cost $50 each and retail for $115. The company
estimates that 5 percent of the units will involve a claim under the warranty. The company esti-
mates that the average warranty claim will cost the company $25. Under the accrual basis of
accounting, the estimated warranty expense for the 20X1 sales must be recognized and
matched against these sales. Based on this information, how much warranty expense should
be recorded for 20X1?
A debt that takes the company longer than one year to satisfy is classified in
the balance sheet as a long-term liability. If the time period of a long-term lia-
bility is reduced to one year or less, the debt should then be moved into the
current liability section. Since most long-term debts carry an interest obliga-
tion, the interest accumulation should be shown as a current liability.
Debts are sometimes payable in installments. When the year begins, the
amount to be paid during the ensuing year should be moved from the long-
term to the current liability section. Examples are mortgages, bonds, deben-
tures, and notes payable with maturity dates later than one year.
Long-term debt is often used as a permanent source of funds for financ-
ing growth, since the cost (interest) of long-term debt is usually fixed. The
use of long-term debt can leverage earnings, which means that the fixed cost
of long-term debt can mean that greater earnings in high-revenue years can
be achieved than could be realized with variable-cost financing. In addition,
the interest paid on long-term debt is tax deductible as a business expense;
therefore, the real cost of long-term-debt financing is less than the cost of eq-
uity financing (dividends), which is not tax deductible.
Long-term debt may be subject to various restrictions or covenants. Since
these may include working capital ratios, debt levels, dividend restrictions, etc.,
the financial statement user should review the notes to the financial statements
to determine whether there are covenants that may affect the ability of the com-
pany to repay other obligations. Two popular types of long-term liabilities—
mortgage payable and bonds payable—are detailed in the sections that follow.
Mortgage Payable
A mortgage payable comes into existence when real property is pledged as
security for a loan. The mortgage creates a lien on the property to secure pay-
ment so that should the borrower default, the pledged assets can be sold by
the lender, and the proceeds from the foreclosure sale used to satisfy the debt.
If the pledged asset’s value is less than the total amount of the mortgage ob-
ligation, the mortgage holder becomes a general creditor for the difference.
Bonds Payable
Bonds payable are long-term promissory contracts, called indentures, that
promise to pay a specific amount of money at a specified time as well as to
pay periodic interest on the outstanding principal. The following are descrip-
tions of several types of bonds.

Debenture Bonds. This is an obligation protected not by collateral or tan-

gible assets, but only by the general credit rating of the issuer. There may
be requirements included to protect the buyer. Requirements for such
protective measures may include maintenance of a specified working
capital ratio, immediate maturity of the issue in case of default in interest
payments, and restrictions on dividends to stockholders.
Guaranteed Bonds. A bond is guaranteed if the payment of principal and
interest is guaranteed by a person or company other than the issuer.
Income Bonds. With income bonds, the payment of interest income de-
pends on the issuing company’s earnings. If earnings are sufficient, the
interest payments will be made. If the earnings are not sufficient, interest
payments may be skipped or deferred to a future date. If the interest pay-
ments are deferred to a future date, the income bond is called cumulative.
If the bond interest is cumulative, interest that cannot be paid in one pe-
riod will be carried forward as a lien against future income.
Corporate bonds may be classified in more detail than income bonds ac-
cording to such factors as the way the bonds are registered, pay interest,
make payments, or mature.
Registered Bonds. These bonds are issued in the name of the owner. When
a registered bond is sold, the seller must surrender the certificate. A new
certificate is issued to the buyer. Periodically, the bondholders of record
will receive interest checks.
Bearer Bonds. Also known as coupon bonds, these bonds are not recorded in
the name of the owner; ownership may be transferred by delivery without
endorsement of the bond showing the transfer of ownership by a former
owner. Interest coupons are attached to the bond. Periodic interest is paid
by presenting the appropriate coupon at a bank. Bearer bonds eliminate
the need for recording changes in ownership and preparation and mailing
of the interest checks. However, since they are not registered, the bond-
holder does not have the protection that registered bonds offer.
Term Bonds. These bonds are an issue that has the same maturity date.
Serial Bonds. These bonds are an issue that matures in installments.
Convertible Bonds. These bonds are convertible into another security, usu-
ally equity.
Deep Discount or Zero Coupon Bonds. These are issues that are sold at a dis-
count and provide that all the interest is earned by paying the full face
value at maturity.
Bonds should be presented on the balance sheet in a manner detailed

enough for the reader to understand. Disclosure of only the face value of out-
standing bonds is not sufficient. The preferred method is to give a description
of the security, the interest rate it bears, and its maturity date. This informa-
tion is usually presented in the footnotes.

3. Match the type of bond with its definition.

A. _____ Serial bond
B. _____ Convertible bond
C. _____ Debenture bond
D. _____ Registered bond
E. _____ Guaranteed bond
Definitions:
1. A bond with interest and principal payments guaranteed by a third party
2. A bond that can be exchanged for another security, such as shares of common stock of the
issuing company
3. A bond that matures in installments
4. A bond that is backed by only the issuer’s promise to pay
5. A bond issued in the name of the owner
4. Identify the following liabilities as being either CL (current liabilities) or LTL

(long-term liabilities).
A. Accounts payable _____
B. Current portion of long-term debt _____
C. Mortgage payable _____
D. Dividend payable _____
E. 30-year bond payable _____
F. Zero coupon bond maturing in 5 years _____
G. Wages payable _____
OFF-BALANCE-SHEET FINANCING
Off-balance-sheet financing is a form of utilizing resources without showing
the source of funding for those resources (which often is debt or equity). One
common example of off-balance-sheet financing is operating leases. Generally
accepted accounting principles in the United States have set numerous rules
for companies to follow in determining whether a lease should be capitalized
(included on the balance sheet) or expensed (and kept off the balance sheet).
Significant forms of off-balance-sheet financing should be disclosed in the
notes to the financial statements. The term “off-balance-sheet financing” came
into use during the Enron bankruptcy.
OWNERS’ (OR SHAREHOLDERS’) EQUITY

Owners’ equity is defined as the amount of right or interest investors have in
the assets of an enterprise after all liabilities owed to the company’s creditors
are satisfied.

There is no guarantee, however, that the amounts shown under the own-
ers’ equity section of the balance sheet will be received by the owners. A com-
pany that is a going concern may not liquidate its assets in the near future,
and even if liquidation occurs, management may not be able to generate
enough cash to pay off the liabilities and cover the owners’ investment.
Owners’ equity is usually divided into four parts:
1. Capital stock at the par or stated value
2. Additional paid-in capital or amounts paid over par
3. Retained earnings representing the undistributed earnings of the entity
4. Treasury stock
Capital Stock
Often, the ownership interest of a corporation is described in terms of capital
stock. Owners of a corporation buy shares of capital stock; the stock certifi-
cates are evidence of ownership. Four basic rights are inherent in the owner-
ship of stock. If only one class of stock exists, these rights are shared by the
stockholders in proportion to the number of shares of stock they each own.
These rights are:
1. The right to vote for corporate directors and thereby be represented in
the company’s management
2. The right to share in the profits of the business by receipt of dividends de-
clared by the directors
3. The right to share in the distribution of cash or other assets in the event
of corporate liquidation
4. The preemptive right to purchase additional shares, in proportion to one’s
present holdings, in the event that the corporation elects to increase the
number of shares of outstanding capital stock

Paid-in surplus is capital paid in excess of par or contributed by stockholders
or outsiders. In other words, it is the total in excess of the par, or stated value
of the stock, and is separated from retained earnings and capital stock on the
balance sheet. To illustrate the concept of additional paid-in capital, assume
a sale was made of $100,000 of par value, common stock for $115,000. The
$115,000 is debited to the cash account. However, because the stock had a par
value of $100,000, only $100,000 would be added to the capital stock account.
The excess ($15,000) of the capital received ($115,000) over the par value of
the capital stock ($100,000) should be entered into an account called additional
paid-in capital.

5. If a company issues 20,000 shares of common stock with a $40 par value at an
issue price of $45:
A. How much total capital would be raised?
B. How much of the capital would be classified as capital stock?
C. How much capital would be classified as additional paid-in capital?
Retained Earnings
Retained earnings are the accumulated profits that have not been distributed
to the shareholders through payment of dividends. A portion of the retained
earnings can be earmarked for purposes other than dividend distribution.
These are labeled restricted earnings. This appropriation reduces the amount
of retained earnings that are free and available for dividends. When the need
for the appropriation passes, the dollar amount set aside is returned to the
regular account, again available for dividends. Appropriations should be dis-
closed clearly in the equity section of the statement and are often footnoted
to provide full disclosure. Among the types of restricted earnings are appro-
priations for plant expansion and contingencies.
Treasury Stock
This is a corporation’s own stock that has been issued or reacquired. Treasury
stock can be resold, but the purchase of treasury stock by the company creates
a temporary reduction in paid-in capital. As shown in the example balance
sheet in Exhibit 4–1, treasury stock is negative equity; the amount paid for
the stock ($22,500 on the December 31, 20X2 balance sheet) must be deducted
from stockholders’ equity. Shares of stock in the company’s treasury are not
eligible for dividends, nor do they grant voting rights.
Treasury stock is never classified as an asset. It is contradictory to imply
that a corporation can invest in itself, although treasury stock may be sold to
obtain needed funds. Treasury stock is also used by corporations to award shares
to employees under certain benefit plans such as stock bonuses or pension.
6. A corporation that currently has no treasury stock has a net income of $1,000,000 and out-
standing common stock shares of 200,000. Based on this information, the earnings per share
(EPS) for the common stock is $5.00 per share, which is computed as follows:


Net Income, $1,000,000, divided by 200,000 shares equals $5.00 EPS
A. The stock is selling for $10 per share in the market. Based on the facts, if the company wants
to boost EPS to $6.00 per share, how many shares of stock would it need to repurchase?
B. How much treasury stock (in dollars) does the repurchase represent?
C. Assume that the common stock was purchased to achieve the $6.00 EPS goal and that im-
mediately prior to the purchase of the treasury stock, the equity section of the corporation’s
balance sheet was as follows:
Capital Stock (200,000 Shares Issued at $10 Par)

$2,000,000 Additional Paid-in Capital $10,000
Retained Earnings $100,000
What would the total equity of the corporation be immediately after the repurchase of stock?
Exhibit 4–1 presents the liability and equity section of a company’s bal-
ance sheets.
xhibit 4–1

Example
D
Company Liabilities and Owners’ Equity, Years Ended December 31
20X2 20X1
Current Portion of Long-Term Debt 1,850 5,583
Accounts Payable 642,237 535,610
Long-Term Debt:
Less: Current Portion 1,850 5,553
Owners’ Equity
Common Stock, Issued and
Outstanding: 10,000 Shares $10 Par 100,000 100,000
Additional Paid-in Capital 22,643 22,643
1,193,227 1,115,041
Less: Treasury Stock 22,500
Owners’ Equity $2,083,197 $1,955,808
!

Liabilities fall into one of two broad categories: current or

long-term. Current liabilities are obligations that are to be sat-
isfied or paid within one year, and the source of their payment
is usually current assets. Long-term liabilities are obligations
that mature in a future period beyond one year. Liabilities are
one type of claim (claim by creditors) against the assets of a
company. The owners also have a claim against the assets. This
is called owners’ equity.
Owners’ equity is the book value of the owners’ interest in a company.
Owners’ equity usually includes a number of components, including common
and preferred stock and retained earnings. Common stock is the purest form
of ownership in a corporation and entitles the holder to dividends when de-
clared by the board of directors. Those dividends are paid from retained earn-
ings and therefore are linked to both the corporation’s cash position and its
profits. Preferred stock is also an ownership interest but its dividends are dis-
tinct from common stock dividends in that preferred stock gives the holder
priority when dividends are paid. This means that if there is enough cash and
profits to pay dividends, the preferred stockholders must receive their divi-
dends first.
Sometimes a portion of retained earnings can be re-allocated to a sepa-
rate restricted account. Such a move limits the amount of retained earnings
that can be paid out of the balance of the main retained earnings account.

Review Questions
1. The source of payment for current liabilities is usually: 1. (b)

(a) long-term borrowing.
(b) current cash flow from normal business operations.
(c) capital raised as a result of a common stock issue.
(d) capital raised from floating long-term bonds.
2. Which of the following statements best describes accounts payable? 2. (c)

(a) It is a short-term obligation evidenced by a promissory note.
(b) It is a current liability that also involves accrued interest.
(c) It is a current liability that comes about from purchasing goods and
services from suppliers on account.
(d) It is for such obligations as dividends payable and interest payable.
3. A dividend payable is the result of: 3. (a)

(a) the declaration of a cash dividend (positive vote) by the board of
directors.
(b) an accrual that takes place over time; similar to accrued interest.
(c) the declaration of a stock dividend by the board of directors.
(d) owning another corporation’s bond.
4. Which of the following statements is true with respect to mortgage 4. (c)

payable and bond payable?
(a) A mortgage payable is a long-term obligation whereas a bond payable
is a short-term one.
(b) A bond payable amount is usually secured by company property such
as real estate whereas a mortgage payable is an unsecured debt.
(c) A bond payable is usually an unsecured long-term debt whereas a
mortgage payable amount is a secured long-term debt.
(d) A bond payable is a government obligation whereas a mortgage payable
is usually owed to a bank.
5. Which of the following statements best describes the purpose of 5. (b)

restricted retained earnings?
(a) They are required by state law.
(b) They are an appropriation that reduces the amount of retained
earnings available for dividends.
(c) They are restricted to pay federal or state income taxes.
(d) They are an appropriation that increases the corporation’s ability to
pay future dividends.

ANSWERS TO “THINK ABOUT IT...”

1. 1. D, 2. A, 3. D, 4. A, 5. C
2. 1,000 × .05 × $25 = $1,250
3. A. 3
B. 2
C. 4
D 5
E. 1
4. A. CL
B. CL
C. LTL
D. CL
E. LTL
F. LTL
G. CL
5. A. 20,000 × $45 = $900,000
B. $40 × 20,000 = $800,000
C. ($45 − 40) × 20,000 = $100,000
6. A. At $166,667 outstanding shares, EPS = $6.00; therefore, 33,333 shares need
to be repurchased (200,000 − 166,667).
B. 33,333 shares × $10 = $333,330
C. Equity of $2,110,000 prior to the treasury stock purchase, less the value of
the treasury stock purchased, which is $333,330, equals equity of $1,776,670.

The Income Statement
5
Learning Objectives
to:
• Identify income and expense accounts.
• Identify the various income statement for-
mats.
• Prepare the single-step income statement.
• List the five types of revenue and expense ad-
justments.
INTRODUCTION
The income statement serves three key functions. First, it is a summary of the
revenues and expenses of an entity for a specified period of time. Second, it
summarizes the company’s operational activity. Finally, the income statement
account balances reflect the cumulative activity in the revenue and expense
accounts for the period being reported. This statement is also referred to as
the statement of income, the operating statement, the statement of operations, or the profit
and loss statement.
INCOME STATEMENT FORMAT

An income statement may take one of several forms. The single-step income state-
ment has no provision for intermediate income measurement. It merely deducts
the total of all costs and expenses from the total of all revenues to arrive at a
net income figure. No recognition is given to gross profit or nonoperating in-
come and expenses. Exhibit 5–1 shows an example of the single-step format.
71
xhibit 5–1
Example of a Single-Step Income Statement
ABC Corporation
Income Statement
For Year Ended December 31, 20X2
Revenues:
Net Sales $708,000
Interest Income 3,600
Total Revenues $711,600
Expenses:
Cost of Merchandise Sold $525,000
Selling Expenses 75,000
General Expenses 35,000
Interest Expense 2,400
Total Expenses 637,400
Net Income $ 74,200
The multi-step income statement provides for intermediate income meas-

urement of such items as gross profit, net operating income, and net income.
A distinction is made between operating and nonoperating revenues and ex-
penses. For example, if the company earns revenues from an extraordinary
event, such as the sale of a subsidiary, the revenue is shown separately from
the operating income. The amount of income before taxes reflects pre-tax
earnings and emphasizes the special nature of the income tax levy. The multi-
step income statement is more likely to be found in the more detailed financial
statements prepared for use by management, bankers, and other creditors. Ex-
hibit 5–2 is an example of the multi-step income statement.
1. On a separate peice of paper use the following account balances to prepare a single-step in-
come statement for the XYZ Company. Use the format shown in Exhibit 5–1 as a guide.
(CAUTION: There may be one or two figures that you do not need to prepare the single-step
statement.)

THE INCOME STATEMENT 73
Cost of Merchandise Sold $500,000

Net Sales $850,000
Selling Expenses $70,000
Interest Income $3,000
General Expenses $30,000
Components of an Income Statement

Whatever the format, every income statement details the activity of four types
of economic variables. These variables are:
1. Revenues
2. Expenses
3. Gains
4. Losses
Revenues
Revenues are earned from providing services and selling goods. Under the
accrual basis of accounting, revenues are recorded at the time of providing
the service or delivering the goods, even if cash is not received at the point of
purchase. Examples of revenue accounts include sales, service revenues, fees
earned, and interest earned. The nature of the business operation dictates the
main revenue sources of the entity. Typical revenues of a law firm are from
fees earned; for Walmart, they are from sales (merchandise); for Bank of
America, they are from interest paid on loans made to its customers. A key
quality of revenue is that it is the result of activities that constitute the entity’s
ongoing major or central operations.
Expenses
Expenses are outflows (or other using-up of assets) or incurrences of liabilities
(or both) during a period from delivering or producing goods, rendering serv-
ices, or carrying out other activities that constitute the entity’s ongoing major
or central operations. Expenses are often categorized as cost of goods sold (the
cost of the merchandise or product sold) and operating expenses. Operating
expenses are incurred in carrying out an organization’s day-to-day activities
and include payroll, sales commissions, employee benefits and pension con-
tributions, transportation and travel, rent, amortization and depreciation, re-
pairs, and various types of taxes. Operating expenses are usually subdivided
into selling expenses and administrative and general expenses.

xhibit 5–2
Example of a Multi-Step Income Statement
ABC Corporation
Income Statement
For Year Ended December 31, 20X2
Revenues from Sales:

Sales $720,000
Less: Sales Returns and Allowances $ 6,100
Sales Discounts 5,900 12,000
Net Sales $708,000
Cost of Merchandise Sold:

Merchandise Inventory,
January 1, 20X2 $ 60,000
Purchases $520,000
Less:
Purchase Returns and Allowances $ 9,100
Purchase Discounts 2,500 11,600
Net Purchases $508,400
Add in Transportation 17,400
Cost of Merchandise Purchased 525,800
Merchandise Available for Sale $585,800
Less: Merchandise Inventory,
December 31, 20X2
60,800
Cost of Merchandise Sold 525,000
Operating Expenses:
Selling Expenses:
Sales Salaries Expense $ 60,000
Advertising Expense 11,000
Depreciation Expense 3,100
Miscellaneous Selling Expense 600
Total Selling Expenses $ 74,700
General Expenses:
Office Salaries Expense $ 21,000
Rent Expense 8,100
Depreciation Expense 2,500
Insurance Expense 1,900
Office Supplies Expense 600
Merchandise General Expense 700
Total General Expenses 34,800
Total Operating Expenses 109,500

Income from Operations $ 73,500
Other Income: Interest Income $ 3,600
Other Expense: Interest Expense 2,900 700
Net Income $ 74,200

Gains
Gains are increases in equity (net assets) from peripheral or incidental trans-
cumstances, except those resulting from revenues or investments by owners,
affecting the entity during a period. For example, if a manufacturing company
owns a vacant lot at a cost of $100,000 and sells it for $150,000, it will have a
$50,000 gain (ignoring taxes). That gain is a peripheral or incidental event
with regard to its normal operating activities (manufacturing and selling prod-
ucts) and is therefore not classified as a revenue item, as it is not from normal
(day-to-day) operations.
Losses
Losses are decreases in equity (net assets) from peripheral or incidental trans-
actions on an entity and from all other transactions and other events and cir-
cumstances, except those that result from expenses or distributions to owners,
affecting the entity during a period.
Gains and losses can be widely varied, but the key is that they are of a
non-normal type of transaction, i.e., sale of investments, theft, sale or closing
of a plant, etc. If the gain or loss is of an unusual and infrequent nature, it is
usually classified as an extraordinary item and is presented below the income
from operations. The purpose is to separate nonrecurring items from normal
operations in order to make the components of income clear to the reader.
To summarize: Revenues and expenses are the recording of transactions
that are the normally occurring types of business in which an enterprise is
engaged. The result of these transactions represents the income or loss from
operations. Gains and losses are the result of transactions that are outside the
normal realm of operations; for example, the closing of a plant is usually pre-
sented as an extraordinary item.
Comprehensive Income
Comprehensive income is a company’s change in total stockholders’ equity
from all sources other than the owners’ of the firm. It is calculated as follows:
Net income (or net loss) plus unrealized gains (losses) on available-for-sale invest-
ments and foreign-currency translation adjustments
Net income, not comprehensive income, is used to calculate the earnings
per share of a company. Exhibit 5–3 shows an example of a statement of com-
prehensive income.

2. Match the revenue or expense described with the type of company.
Type of Revenue or Expense Type of Company
1. ___ Legal fees earned A. Landscaping company

2. ___ Interest income B. Insurance company
3. ___ Premiums
C. Bank
4. ___ Sales of merchandise
D. Law firm
5. ___ Interest expense on time deposit
accounts E. Retailer
6. ___ Cost of materials, labor, and
overhead of products sold F. Manufacturer
7. ___ Depreciation expense on trucks
and lawn mowers
xhibit 5–3
Example of a Statement of Comprehensive Income
Statement of Comprehensive Income

For the year ended December 31, 20X1
Amounts are in thousands (000s)
Net Sales $15,000

Cost of goods sold 9,000
Gross profit $6,000
Operating expenses 4,000
Operating income $2,000
Interest income 15
Income before taxes $2,015
Income taxes 800
Net income $1,215
Other comprehensive income:
Unrealized gains on available-for-sale investments 500
Loss on foreign currency translation 100
Comprehensive income $1,615

CASH VERSUS ACCRUAL BASIS OF

ACCOUNTING
The analyst must be aware of the accounting basis, cash or accrual, used by
the company whose statements he or she is examining. The cash basis is gen-
erally used by small businesses in which inventories, receivables, and payables
are not a material factor.
Cash Basis
A rule for the cash basis of accounting for revenues and expenses is:
1. Revenue is recorded as earned when it is received or collected.
2. Expense is recorded as incurred when it is paid.
Objections to the cash basis are numerous. The primary objection con-
cerns the difficulty of matching current costs with current revenues. The time
elapsed between the production of revenue and its ultimate recognition affects
the financial and managerial position of a company. If expenses are prepaid
(for example, prepaid rent), they are taken entirely as an expense at the time
of a payment and will produce a calculated income. The calculated income
will be understated in the period of payment and overstated in the subsequent
period or periods that received the benefit of the expenditure.
Accrual Basis
The accrual basis of accounting is used by larger firms and is an acceptable
method for reporting revenue. On the accrual basis, revenue is allocated to
the period or periods it is earned, regardless of when it is collected. Expenses
are applied to the period in which they are incurred rather than the period of
their payment or satisfaction. The summarizing rule for the accrual basis of
accounting is:
1. Revenue is recorded as such in the period it is earned, regardless of when
it is received.
2. Expense is recorded as such in the period it is incurred, regardless of when
it is paid.
Since an important goal of the accrual basis of accounting is to match

costs and revenues for a particular period, adjustment of account balances is
necessary at year’s end.
APPORTIONMENT OF REVENUES AND

EXPENSES
In its operations during an accounting period, a company is affected by accrued
and deferred expenses and revenues. Transactions that were recorded in ac-
counts affecting the balance sheet and income statement during one period
may influence other accounting periods. Therefore, end-of-period adjustments

are necessary. Financial transactions or events that have not been recorded as
of year’s end will have to be recorded in order to bring all accounts to their
proper balances as of the statement date.
The diversity of year-end adjustments fits into five categories:
1. Prepaid expenses requiring apportionment
2. Unearned and recorded revenues requiring apportionment
3. Unrecorded accrued revenues
4. Unrecorded accrued expenses
5. Valuation of accounts receivable and investments
Prepaid Expenses Requiring Apportionment

Outlays that contribute to revenues of a particular period are called expenses.
For example, prepaid or unexpired insurance for a three-year coverage is an
asset at the time of the cash outlay. However, this cost eventually expires and
requires an entry that would move the expired portion of insurance from an
asset account to an expense account. This periodic matching of the use of an
asset with the period in which it is used is an excellent example of the concept
of matching of revenue and expense.
Unearned and Recorded Revenues Requiring Apportionment

Suppose $24,000 was received in advance for the 24-month rental of a ware-
house unused by the company. Revenue income, if recorded as $24,000, would
produce an overstated figure, with the resulting income and income tax over-
stated. The later period or periods would receive the benefit of the rent pre-
payment but would not be charged with any of the expense. Matching of costs
and revenues would not occur. In this case, a liability for the unearned portion
would be set up and the revenue account credited for the amount earned. The
liability account of unearned revenue may need to be split between a current
and noncurrent liability, depending on how many months are unearned and
the fiscal year of the company. For example, if 18 months were unearned, 12
months would be current and 6 months would be noncurrent as of that balance
sheet date.
Unrecorded Accrued Revenues

Accrued revenues occur when revenue is earned but not yet collected. At the
end of an accounting period, some accrued revenues may need to be recorded.
Examples of unrecorded revenues are interest revenue owed to the company
for completed services or delivered goods that, for a variety of reasons, have
not been billed (invoiced) to the customer. For example, assume a bank’s cus-
tomer owes 12% interest on a three-year, $10,000 note (loan) receivable but
has not yet made a payment; still, one month of interest has accrued. That
would mean that $100 ($10,000 x .12/12 months) of accrued interest would
need to be recorded. Another example: A service worth $1,000 was performed
for a customer on the last day of the year but the customer won’t pay until
next month and an invoice has not yet been mailed out. Under accrual ac-
counting rules, the revenue is earned when the service has been provided or

the goods have been delivered and so the $1,000 should be recognized as ac-
crued revenue.
Unrecorded Accrued Expenses

Accrued salaries serve as an illustration here. If payroll accrued at a daily rate
of $20,000 and was not recorded for three days at year’s end, the expense for
payroll would be understated, income overstated, and income tax computed
thereon too high. The accounting period that followed would be affected con-
versely. To correct this balance, a current liability would be recorded and the
correct expense accounts would be charged for $60,000. This reasoning is the
same for any other expense incurred but not paid during the accounting pe-
riod.
Valuation of Accounts Receivable and Investments

Whenever a business makes sales on account, some accounts receivable prove
wholly or partially uncollectible. In order to effect a proper matching of costs
and revenues, the estimated loss arising from a credit sale should be recog-
nized in the period the sale was made. This requires an evaluation of the re-
ceivables to determine the approximate amount of the loss. Once the estimate
is established, it should be reflected on the accounts receivable balance at
year’s end. An account for bad debts expense (also often called the allowance
for doubtful accounts) contains the total of the periodic expense to be used
in the income statement; a contra-valuation account follows the accounts re-
ceivable account to the balance sheet. Income is reduced by the bad debts es-
timate, and accounts receivable is reduced by the contra account. The balance
sheet equation will be in balance. Here is an example. Management estimates
that 2 percent of its credit sales will be uncollectible. Sales for the past year
were $1,000,000, and $600,000 of that amount was on credit. Therefore, the
estimate for bad debts is $12,000. If the company has $50,000 of accounts re-
ceivable at the end of the year, the net book value of the accounts receivable
reported on the balance sheet as of the end of the year would be $38,000
($50,000 less $12,000).
Valuation of Marketable Securities

The valuation accounts for adjusting marketable securities for changes in mar-
ket values (also called fair market value) are covered in Chapter 3.
3. Match the description of an apportionment of a revenue or expense with one of the four appor-
tionment descriptions.

___ A. During the year 20X1, a civic center sells a three-concert ticket package for a price of
$60 to 10,000 customers. By year end 20X1, two of the concerts had been performed.
Therefore, two-thirds of the $600,000 revenue ($400,000) was recognized as revenue
for 20X1, and $200,000 (the remaining unearned revenue) is shown on the 20X1 year-
end balance sheet as an unearned revenue (liability).
___ B. A company rents a warehouse. The company makes a rental payment covering the next
24 months on April 1, 20X1. At year end, the remaining unexpired rent, which represents
15 months, is shown on the balance sheet as an asset.
___ C. At the end of the year, the balance of accounts receivable is $150,000. However, it is
estimated that $20,000 of the receivables will not be collected. The book value of the
receivables is adjusted to show $130,000 as the amount of net receivables.
Apportionment Descriptions
1. Prepaid expenses requiring apportionment
2. Unearned and recorded revenues requiring apportionment
3. Unrecorded accrued expenses
4. Valuation of accounts receivable and investments
The income statement is a summary of the revenues and ex-

penses of an entity for a specific period of time. It shows the
calculation of net income (revenues less expenses). Two for-
mats are used to present the income statement: the single step
and multi-step formats.
When accountants prepare an income statement using
accrual accounting principles, adjusting entries are necessary
to assure that revenues and expenses are properly reflected.
There are five categories of adjustments: prepaid expenses requiring appor-
tionment, unearned and recorded revenues requiring apportionment, un-
recorded accrued revenues, unrecorded accrued expenses, and valuation of
accounts receivable and investments. Adjustments are performed at end of
the accounting period, just before the financial statements are prepared.

Review Questions
1. The multi-step income statement provides for intermediate income 1. (d)

measurement of such items as ______, net operating income, and
net income.
(a) cost of goods sold
(b) earnings before interest
(c) depreciation
(d) gross profit
2. A manufacturing company owns a truck with a net book value of 2. (a)

$14,000. It sells the truck for $10,000 and therefore incurs a $4,000 loss.
Which of the following best describes how the loss will be reported on
the company’s income statement?
(a) It will be shown as a loss, separated from expenses since it is not
incurred in the normal course of operating activities.
(b) The $4,000 loss will be shown as depreciation expense (for the truck)
for the period in which the sale occurs.
(c) It will not be shown separately as it is a type of revenue ($10,000)
because the truck was sold.
(d) It will be part of cost of goods sold reported for the same period of the
sale.
3. A company purchases supplies for $5,000 on January 2, 20X1 and 3. (b)

initially records the purchase as an asset. During the year, another
$2,000 of supplies are purchased and are also added to the supplies
account. On December 31, 20X1 in anticipation of preparing a balance
sheet and income statement, the staff takes a count of the supplies that
remain on hand. The count reveals that $2,500 of supplies have not yet
been used. Which of the following best describes the adjusting entry
that is needed?
(a) No adjusting entry is needed because the company still owns some of
the supplies and therefore won’t need to write them off until they are
used.
(b) The supplies account needs to be reduced by $4,500 and the supplies
expense account needs to be increased by $4,500 to recognize the use
of the asset during the year.
(c) The cash account needs to be reduced by $7,000 for the cost of the
supplies.
(d) The cash account needs to be reduced by $7,000 and increased by
$2,500 by the end of the year.

4. If a professional sports team sells season tickets during the summer 4. (b)
months (games will be played in the time period of September through
February), what will the team most likely need to do at the end of the
fiscal year (December 31)?
(a) Increase cash for the sale of the tickets and recognize revenue for all
the tickets sold.
(b) Determine what percentage of all games for the season have been
played by year end and recognize a proportional amount as revenue
and reduce its related liability (unearned revenue) for the same
amount.
(c) Determine what percentage of all games for the season has been played
by year end and increase cash by a proportional amount.
(d) Adjust (reduce) operating expenses for the year by a proportion equal
to the number of games played by December 31 divided by the total
number of games on the schedule.
5. Management estimates that 4% of its credit sales will be uncollectible. 5. (c)

Sales for the past year were $2,000,000 and $1,600,000 of that amount
was on credit. The end of year balance for accounts receivable is $120,000.
Which of the following is correct?
(a) There are about $80,000 of bad debts that most likely exist as of
year end.
(b) The net receivables are $40,000 as of year end.
(c) The net receivables are $56,000 as of year end.
(d) The bad debt expense for the year will be $56,000.
ANSWERS TO “THINK ABOUT IT...”

1. Revenues:
Net Sales $850,000
Interest Income $3,000
Total Revenues $853,000
Expenses:
Cost of Merchandise $500,000
Selling Expenses $70,000
General Expenses $30,000
Total Expenses $600,000
Net Income $253,000
2. 1. D, 2. C, 3. B, 4. E, 5. C, 6. F, 7. A
3. A. 2
B. 1
C. 4

The Statement of Cash Flows
6
Learning Objectives
to:
• Describe the kinds of information disclosed
by the statement of cash flows.
• List the three key areas of cash flows dis-
closed in a statement of cash flows.
• Identify and describe the two accepted state-
ment of cash flows formats.
• Explain the free cash flow concept
INTRODUCTION
A balance sheet (or statement of financial position, as it is often called) is a snap-
shot of the amounts of assets, liabilities, and owners’ equity at a specific mo-
ment in time. Balance sheets are prepared at least annually, often quarterly,
and even perhaps as often as monthly. An income statement is a summary of
revenues and expenses that covers a period of time, such as a year, a quarter,
or a month.
Although the balance sheet and income statement are prepared period-
ically and do disclose much about the condition of a company and its recent
earnings history, they do not tell the statement user much about how the com-
pany manages cash. Since cash flow is what companies use to pay bills and re-
ward the owners with dividends, cash activity is very important and is
summarized in the statement of cash flows, a statement that is required to be
issued along with the balance sheet and income statement.
This chapter explains the format and objectives of the statement of cash
flows, as required by FASB 95. FASB 95 was issued in 1987 by the Financial
Accounting Standards Board and superseded APB 19, which had been in place
83
84 HOW TO READ AND INTERPRET FINANCIAL STATEMENTS, SECOND EDITION
for many years and stipulated how to prepare cash flows statements (previ-
ously called statement of sources and uses of cash). Please note that FASB 95
was subsequently amended by SFAS No. 102 and 104.
In the sections that follow, we examine the two ways of preparing the
statement of cash flows.
THE USEFULNESS OF THE STATEMENT OF

CASH FLOWS
An investor, creditor, or other interested person needs to know how an or-
ganization got where it is and to predict what its prospects are for the reason-
ably near future. There are two reasons why an income statement does not
represent an adequate source of data for this purpose. First, an income state-
ment contains estimates and assumptions that are of a noncash nature. Such
estimates tend to be mixed in with the actual cash-generating and cash-dis-
bursing activities of the business; this mixture is not readily apparent when
simply examining the income statement.
Second, an income statement is most often prepared on an accrual basis.
As such, many of the figures (perhaps significant percentages of various ac-
counts) are far removed from actual cash flow.
The statement of cash flows provides the statement user with an insight into
the planning, decision making, and success of management in handling many
of the actions relating to cash. It also helps answer these important questions:
1. What amount of cash was generated and used by operations?
2. What was the source of cash invested in new plant and equipment?
3. How was the cash raised? From issuing stock or floating a bond?
4. Why, despite a healthy net income, was the cash balance lower than the
previous period?
5. How was the company able to pay dividends?
The purpose of the statement of cash flows is to summarize the results

of the other interrelated financial statements for the current period and to
present reasons for the inflows and outflows of cash.
THE NATURE OF THE STATEMENT OF

CASH FLOWS
The statement of cash flows summarizes the firm’s many sources and major
uses of cash in three key areas during a period of time:
1. Cash flows from operating activities. These are cash flows from day-to-day,
income-producing activities. They include the activities that are not in the
categories of investing and financing, described in the following section.
2. Cash flows from financing activities. These include issuance of capital stock,
debt securities, dividend payments, repayment of debt, and purchase of
treasury stock.

THE STATEMENT OF CASH FLOWS 85
3. Cash flows from investing activities. These include purchases and sales of pro-
ductive assets and other companies’ debts (bonds and notes) and equity
(common and preferred stocks issued by other companies).
Each of these three key areas is presented in a different section of the
statement of cash flows. The following outline details the major items in each
of the three sections. Please note that the outline contains examples of items
to be found in each section (operating, financing, and investing) but is not in-
tended to be all-inclusive.
A. Cash Flows from Operating Activities (covers all transactions not detailed
in the specifics of investing or financing activities)
1. Cash Inflows
(a) Sales of goods and services for cash and the collection of accounts
receivable
(b) Interest and dividends received on investments
2. Cash Outflows
(a) Purchases of materials and supplies
(b) Employee compensation
(c) Taxes
(d) Interest on borrowed money
B. Cash Flows from Financing Activities
1. Cash Inflows
(a) Issuing (selling) more common or preferred stock
(b) Issuing bonds, notes, and mortgages
2. Cash Outflows
(a) Dividends of common or preferred stock paid to owners
(b) Principal payments on bonds, notes, and mortgages
(c) Buying of stock for treasury purposes
C. Cash Flows from Investing Activities
1. Cash Inflows
(a) Sale of property, plant, and equipment
(b) Sale of a portion of the business, such as a division
(c) Sale of securities (investments)
2. Cash Outflows
(a) Acquisition of property, plant, and equipment
(b) Making loans to another organization
(c) Purchase of securities (investments)
Significant Noncash Financing and Investing Activities

In addition to the financing and investing activities, noncash financing
and investing activities, if significant, must be disclosed in a supplemental
schedule or reported in the footnotes to the statement of cash flows. For ex-
ample, the exchange of shares of $100,000 of stock for land valued at
$100,000, although not a cash transaction, could have a significant effect on
future cash flows and thus is a noncash financing and investing activity that

should be disclosed in the statement of cash flows. Other examples of signif-

icant noncash financing and investing activities include:
• Conversions of debt to equity
• Exchanges of assets for other assets
• Receipt of donated property
1. Classify each of the following as either:

O. Operating Activity
F. Financing Activity
I. Investing Activity
N. Noncash Financing or Investing Activity
A. ____ A company sold $100,000 of common stock to investors.
B. ____ A company used $150,000 to acquire 10,000 shares of its own stock.
C. ____ A company collected cash from its customers for goods sold and services provided.
D. ____ A company purchased a factory for $1.5 million in cash.
E. ____ A company purchased a factory for $1.5 million worth of its preferred stock.
F. ____ A publishing company paid $50,000 cash for a copyright.
STATEMENT OF CASH FLOWS: FORMAT

ALTERNATIVES
FASB allows two alternative formats for the statement of cash flows. One
method is called the direct method; the other is called indirect. Although FASB
allows either method, it recommends the direct method.
The Direct Method

The direct method reports the major classes of net cash flows from operating
activities by listing all major operating cash receipts and payments. The direct
format must disclose at least the following categories of cash flows:
• Cash collected from customers
• Interest and dividends received
• Other operating receipts
• Cash paid to employees and suppliers
• Interest payments
• Income tax payments

xhibit 6–1
Example Statement of Cash Flows (Direct Method)
Cash Flows from Operating Activities
Cash Received from Customers $8,150,583

Other Income 6,429 $8,157,012
Deduct:
Cash Paid to Suppliers and Employees $ 7,887,687
Interest Paid 13,026
Income Taxes Paid 68,821 7,969,534
Cash Flows from Financing Activities

Cash from Notes Payable—Bank $ 16,033
Deduct:
Payment of Notes Payable—Bank $ 33,703
Payment of Notes Payable—Other 10,000
Purchase of Treasury Stock 22,500 66,203
Net Cash Flow from Financing Activities ($ 50,170)
Cash Flows from Investing Activities

Purchase of Property, Plant, and Equipment 59,290
Net Cash Flow from Investing Activities ($125,296)
Net Cash Increase $ 12,012

Beginning Cash Balance 37,988
Ending Cash Balance $ 50,000
The advantage of the direct method is that it gives the details of operating
cash flows. The main disadvantage is that it can be costly to collect the de-
tailed cashflow data. An example statement of cash flows is shown in Exhibit
6–1.
The Indirect Method

The indirect method requires that net income and net cash flow from oper-
ating activities be reconciled through a series of adjustments. These adjust-
ments include reducing net income for noncash revenues, increasing net
income for noncash expenses (such as depreciation), and adjusting net in-
come for changes in working capital accounts. These adjustments (reconciling
net income to net cash flow) may appear in the body of the statement, as
shown in Exhibit 6–2, or they may appear in a supplemental schedule. The
adjustments should at least include:

xhibit 6–2
Example Statement of Cash Flows (Indirect Method)
Cash Flows from Operating Activities
Net Income $ 78,186

Add:
Depreciation $ 67,933
Increase in Accounts Payable 106,627
Reduction in Other Assets 2,000 176,560
$254,746
Deduct:
Increase in Accounts Receivable $ 23,197
Increase in Inventory 35,570
Increase in Prepaid Expenses 2,247
Reduction in Accrued Expenses 933
Reduction in Accrued Taxes 5,321 67,268
Cash Flows from Financing Activities

Cash from Notes Payable—Bank $ 16,033
Deduct:
Payment of Notes Payable—Bank $ 33,703
Payment of Notes Payable—Other 10,000
Purchase of Treasury Stock 22,500 66,203
Net Cash Flow from Financing Activities ($50,170)
Cash Flows from Investing Activities

Purchase of Property, Plant, and Equipment 59,290
Net Cash Flows from Investing Activities ($125,296)
Net Cash Increase $ 12,012
Beginning Cash Balance 37,988

Ending Cash Balance $ 50,000
• Deferrals of past operating receipts and payments

• Accruals of expected future operating receipts and payments
• Changes in receivables, inventories, payables, and other operating current
assets and liabilities
• Other classes of reconciling items
• Noncash gains and losses
The indirect method, in contrast to the direct method, does not provide
a list of operating cash flows.

FREE CASH FLOW

There is a growing body of analytical techniques that utilize information from
the statement of cash flows. One such technique is the free cash flow (FCF)
calculation. The following is the formula for calculating one version of FCF:
Cash Flow from Operations – Capital Expenditures Required to Maintain
Productive Capacity Used in the Production of Income – Dividends
= Free Cash Flow (FCF) (version 1)
One major difficulty in calculating FCF (version 1) is determining the

capital expenditures required to maintain productive capacity used in the pro-
duction of income. Very few companies disclose the amount of capital expen-
ditures needed to maintain productive capacity. However, there are situations
in which the amount of capital expenditures needed to maintain productive
capacity is known. Version 2 of the FCF calculation is:
EBIT (1 – Tax Rate) + Depreciation & Amortization – Change in Net Working
Capital – Capital Expenditure = Free Cash Flow (FCF) (version 2)
EBIT is earnings before interest and taxes and can be derived from the com-
pany’s income statement. This version (version 2) does not subtract dividends
and therefore produces a free cash flow amount that is available to pay divi-
dends and other costs of capital.
If a company has positive FCF, it had adequate cash flow during the pe-
riod to keep productive capacity at current levels. Positive FCF is crucial for
long-term growth. Think of it this way: adequate free cash flow allows a com-
pany to pay dividends (and therefore reward stockholders) and do the things
that help growth, such as make acquisitions, develop new products, and invest
in new property, plant, and equipment.
2. Using the information from Exhibit 6–1 and the version 1 formula of FCF, calculate:
A. the free cash flow, assuming that the capital expenditures required to maintain productive
capacity used in the production of income are exactly equal to the amount of cash flow spent
on property, plant, and equipment.
B. the FCF if the company paid $20,000 in dividends.
3. Assume that a company has EBIT of $1,000,000 and the following facts also exist:
Tax rate: 35%
Depreciation for the year: $100,000
Change in WC: +$50,000
Capital expenditures for the year: $150,000


A. Calculate the Free Cash Flow (FCF) using the version 2 method.
FCF = $___________
B. If a similar cash flow projection is made for next year and management is contemplating another
$600,000 of capital spending above current year levels, what do you think would have to happen
to carry out management’s plans?
Under generally accepted accounting principles (GAAP), a

full set of financial statements includes the balance sheet, in-
come statement, and statement of cash flows, as required by
FASB. The statement of cash flows must cover the same period
as the income statement. The statement of cash flows provides
insight into how cash has been generated and how it has been
used by a company. In addition, the statement of cash flows
allows interested parties to understand how cash inflows might
be generated and used in the future.
There are two acceptable formats for the statement of cash flows: direct
and indirect. Both the direct and indirect methods classify cash flows accord-
ing to operating, investing, and financing activities. The different presentations
affect the operating section only. The investing and financing sections do not
differ between the two presentations. Some experts believe that the direct
method is more revealing of a company’s ability to generate sufficient cash
from operations to pay debts, reinvest in operations, and make distributions
to owners. The indirect method focuses on the difference between net income
and net cash flow from operations and provides useful links among the state-
ment of cash flows, the income statement, and the balance sheet.
One metric that can be calculated using the statement of cash flows is
free cash flow (FCF). This chapter shows how FCF is calculated using the
statement of cash flows and how it is a useful measurement to be considered
by management and external parties such as investors and creditors.

Review Questions
1. FASB 95 established standards for: 1. (b)

(a) how to prepare the balance sheet on a cash basis.
(b) cash flow reporting.
(c) the sources and uses of funds statement.
(d) preparing the income statement on a cash basis.
2. Which of the following cannot be determined from the statement 2. (d)

of cash flows?
(a) The amount of cash generated and used by operations
(b) The source of cash invested in new plant and equipment
(c) The amount of cash raised from issuing stock or floating a bond
(d) The amount of stock awarded in a stock split during the period
3. Which of the following entries would be found in the operating 3. (c)

activities section of the statement of cash flows?
(a) Cash received from selling the firm’s common stock
(b) Cash received from dividends on marketable securities
(c) Cash received from the sale of goods and services
(d) Cash paid to acquire property, plant, and equipment
4. Which of the following statements describes the direct method of the 4. (a)
statement of cash flows?
(a) It reports the major classes of net cash flows from operating activities
by listing all major operating cash receipts and payments.
(b) It requires that net income and net cash flow from operating activities
be reconciled through a series of adjustments.
(c) It shows all cash and noncash activities that impact the ability to pay
interest and dividends on corporate capital.
(d) It only shows cash flows from operating activities and excludes cash
flows from financing and investing activities.
5. Which of the following statements describes the indirect method of the 5. (b)
statement of cash flows?
(a) It reports the major classes of net cash flows from operating activities
by listing all major operating cash receipts and payments.
(b) It requires that net income and net cash flow from operating activities
be reconciled through a series of adjustments.
(c) It shows all cash and noncash activities that impact the ability to pay
interest and dividends on corporate capital.
(d) It only shows cash flows from operating activities and excludes cash
flows from financing and investing activities.


1. A. F
B. F
C. O
D. I
E. N
F. I
2. A. $128,188
B. $108,188
3. A. $450,000
B. Another $600,000 of capital spending will not be possible
without additional financing from outside the company.

Balance Sheet Analysis
7
Learning Objectives
to:
• List the liquidity, activity, and leverage ratios
used to analyze a balance sheet.
• Explain the purpose of horizontal and verti-
cal analysis.
INTRODUCTION
The prior chapters have presented background on the preparation of financial
statements, their components, and the efforts of the accounting profession to
provide consistent financial statements that are materially correct. The assur-
ance that we have financial statements that present each balance in a consistent
manner from year to year allows us to analyze financial statements on a com-
parative basis for a single company and for others in the same industry.
The aim of financial statement analysis depends on the user. Banks and
creditors are interested in the business entity’s ability to meet liabilities in the
short run. Bondholders and shareholders, both current and potential, are in-
terested in the capital structure, earnings, and how efficiently the entity uses
its resources. Management is interested in analysis and trends that disclose
strengths, weaknesses, and potential problems.
93
RATIOS IN FINANCIAL STATEMENT

ANALYSIS
When analyzing financial statements, the first task is to determine what in-
formation is being sought. Many analytical techniques can disclose informa-
tion about a company. Once the financial statement analyst knows what
information is being sought, the proper technique can be used. Financial ratios
are the primary analytical tool of the analyst. Ratios are easy to compute, ver-
ifiable, and allow for period-to-period and company-to-industry comparisons.

There are some disadvantages to ratio analysis, and caution should be exer-
cised when using ratios. Ratios should not be considered as the only answer
to complex questions. Ratios are only as good as the information contained in
financial statements, which in part consist of historical costs that may not be
in line with reality and estimates and allocations that are somewhat subjective.
In addition, with the possibility of the existence of financial statement errors
and omissions, the financial statement analyst should know that a ratio can be
misleading.
Ratio analysis must be considered as only one step in the complete analy-
sis of a company. Additional avenues of approach should be taken, including
examination of footnotes to the financial statements, review of the nonfinan-
cial material of an annual report, comparison of industry statistics with those
of the company being analyzed, and matching the company’s ratios against
those of a leading competitor.
Finally, a ratio by itself is not of much use. To give ratios some basis for
comparison, the analyst should review one or more of the reference materials
that list industry ratios and averages. Two excellent sources for industry ratios
are Dun & Bradstreet’s Industry Norms and Business Ratios and Robert Morris
Associates’ Annual Statement Studies (for 340 lines of business). Another good
source is the Almanac of Business and Industrial Financial Ratios published by
Prentice-Hall. These volumes are often available at corporate libraries and
business school libraries.
Many libraries, especially those associated with business schools, have
web resources to help students do research on corporate entities. One such
source is Thomson ONE, which provides access to real-time and historical
SEC EDGAR filings. Thomson ONE also includes thousands of research re-
ports. Thomson ONE is published by Thomson Reuters, a leading source of
intelligent corporate financial information.
Another source of financial data and ratios is Mergent Online (www.mer-
gentonline.com). Mergent provides Internet-based access to a detailed and
comprehensive database of global companies. One feature of Mergent Online
is FactSheets Express, which is available for 10,000 U.S. and Canadian com-
panies. It covers essential facts and figures, including a fifteen-year stock price
and volume chart, summary of annual financials, recent quarterly earnings,
and key financial ratios.

BALANCE SHEET ANALYSIS 95
CATEGORIES OF FINANCIAL RATIOS

Financial ratios can be classified into the following categories: liquidity, ac-
tivity, leverage, and profitability. In this chapter, you will learn about liquidity,
activity, and leverage ratios. Chapter 8 presents profitability ratios.
Liquidity Ratios
Liquidity ratios attempt to measure a company’s ability to meet its short- term
obligations. There are two popular liquidity ratios: the current ratio and the
quick (or acid-test) ratio.
Current Ratio
The current ratio expresses how many times the current assets of a company
“cover” current liabilities. For example, using 20X1 figures from Exhibit 7–1,
the company has a current ratio of 1.97, calculated as follows:
Current Assets ($1,759,779)
= 1.97
Current Liabilities ($891,502)
A current ratio of greater than 1 means that the book value of the current
assets is greater than the amount of current liabilities. A current ratio of less
than 1 means that the company does not have sufficient liquid assets to pay
off the current liabilities.
At one time, the rule of thumb was that a current ratio of 2 or greater was
considered adequate. However, that rule of thumb became outdated as analysts
realized that much depends on the industry in which the firm operates. The
best way to evaluate a current ratio of a specific company is to compare it to
an industry average. Thus, if the industry average is 2.5, then the current ratio
of 1.97 is below the industry average and could be a cause for concern.
The current ratio is only one measure of determining liquidity. It does
not answer the questions that better determine true liquidity, such as: How
liquid (good) are the receivables, or how liquid (current) is the inventory?
Quick (Acid-Test) Ratio

In the current ratio formula (current assets/current liabilities), the value of
inventories is included in current assets. That inclusion is a potential draw-
back. Inventories, although technically a member of the current asset family,
could be slow-moving or obsolete and therefore not truly liquid. Current as-
sets also can include prepaid expenses that are of value to the company in the
accounting sense but do not represent an asset available to satisfy current ob-
ligations. The quick ratio, also known as the acid-test ratio, attempts to meas-
ure the firm’s ability to meet its obligations without having to convert
inventories to cash and without considering prepaid expenses.
Using Exhibit 7–1 as an example, the quick ratio for 20X1 is computed
as follows:
Cash and Marketable Securities and Net Receivables ($413,862)

= 0.46
Current Liabilities ($891,502)


xhibit 7–1
A Company’s Comparative Balance Sheet, Years Ended December 31
Assets 20X1 20X0

Current Assets:
Cash $ 50,000 $ 37,989
Inventories 1,343,670 1,308,100
Fixed Assets:
316,881 325,524
Total Assets $2,083,197 $1,954,808

Long-Term Debt
Less: Current Portion (1,850) (5,553)
Owners’ Equity
Common Stock, Issued and Outstanding:
10,000 Shares 122,643 122,643
1,193,227 1,115,041
Less Treasury Stock (At Cost) 22,500 0
1,170,727 1,115,041
Total Liabilities and Owners’ Equity $2,083,197 $1,954,808
!
As was the case with the current ratio, the quick ratio of a company has
analytical usefulness when compared to an industry average. If the quick ratio
industry average is 0.95, and the company quick ratio is 0.46, then the com-
pany is only about half as liquid as the industry average and may be very de-
pendent on the quick turnover of inventories to meet obligations.

1. Using the balance sheet shown in Exhibit 7–2, compute and evaluate the following for 20X1:
Current Ratio _______ (Industry Average = 2 times)
Evaluation: ________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
2. Current Ratio _______ (Industry Average = 2 times)

Evaluation: ________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
Limitations of the Current and Quick Ratios

The current ratio and quick ratio do not constitute an entire liquidity analysis.
These ratios are merely a starting point. Other factors to be considered in-
clude:
• The nature of the business
• The composition of the current assets
• The seasonal nature of the business and how it affects liquidity
• The quality of management
• The probability of real current asset values (market values) deviating
greatly from the book values
• The company’s credit rating and ability to refinance short-term debts
Activity Ratios
Activity ratios measure how efficiently the company manages its assets. Ac-
tivity ratios help answer these questions:
• How well does the company manage accounts receivable?
• How well does the company manage inventory?
• How well does the company generate revenues from its base of assets?


xhibit 7–2
A Company’s Comparative Balance Sheet, Years Ended December 31
Assets 20X1 220X0

Current Assets:
Cash $ 40,000 $ 37,988
Inventories 1,132,559 1,308,100
Fixed Assets:
Total Fixed Assets 314,659 325,524

Total Assets $1,948,969 $1,954,808

Long-Term Debt
Less: Current Portion (2,850) (5,553)
Owners’ Equity
Common Stock, Issued and
Outstanding: 10,000 Shares 122,643 122,643
1,147,888 1,115,041
Less Treasury Stock (At Cost) 22,500 0

Total Liabilities and Owners’ Equity $1,948,969 $1,954,808

There are many activity ratios. The sections that follow present five ac-
tivity ratios:
1. Accounts receivable turnover
2. Average collection period
3. Inventory turnover
4. Number of days’ inventory
5. Total asset turnover
Accounts Receivable Turnover

The accounts receivable turnover, along with the average collection period,
gives an indication as to how well the company is managing its accounts re-
ceivable. The trend of a rising accounts receivable turnover is favorable, since
it means that the company is becoming more effective at collecting the re-
ceivable balances—more effective at “turning over” these balances. The for-
mula for the accounts receivable turnover is as follows:
Net Credit Sales
Average Accounts Receivable
Average accounts receivable, the denominator in the accounts receivable

turnover formula, is determined by a simple average as follows:
Beginning Balance of Accounts Receivables + Ending Receivables
2
Using the example comparative balance sheet and income statement in

Exhibits 7–3 and 7–4, the accounts receivables turnover as of 12/31/20X1 is
34.6, computed as follows:
Net Sales
Accounts Receivable
$8,173,780
$247,856 + 224,657 ÷ 2
The larger the turnover number, the better. If the industry average for
this example is 25, then the company, with an accounts receivable turnover
of 34.6, is more effective at collecting its receivables.
Average Collection Period

The average collection period is the average time it takes to collect a credit
sale. A trend of a falling average collection period means that a company is
probably becoming better at collecting receivables or at judging credit risk. A
rising average collection period means trouble—customers are stretching
their payments. The average collection period is calculated as follows:


xhibit 7–3
Statement of Income, Years Ended December 31
20X1 20X0
Sales $8,173,780 $7,341,704
Gross Profit 2,210,270 2,152,389
Operating Expenses
Selling and Administrative 1,994,054 1,887,420
Interest 13,026 29,966

Profit Before Taxes 141,686 204,037
Provision for Taxes 63,500 87,000
Net Income 78,186 117,037
365 Days
Accounts Receivable Turnover Ratio
For example, using the previous example of an accounts receivable turnover

of 34.6, the average collection period is 10.55 days, computed as follows:
365
= 1.97
34.6
When the average collection period of this example is compared to the

industry average of 14.6 days, the company is collecting receivables faster
(10.54 days versus 14.6 days) than is the industry.
Inventory Turnover
The inventory turnover ratio monitors how effective a company is at manag-
ing its inventory. The ratio represents the number of times during the year
(or period) that a company replaces (“turns over”) its inventory. A rising trend
shows an improving efficiency in managing inventory. This is an indication
that the firm is squeezing more and more sales from a proportionately smaller
inventory investment. The inventory turnover is calculated using the follow-
ing formula:
Cost of Goods Sold
Average Inventory

with the average inventory computed as follows:

Beginning Inventory + Ending Inventory
2
xhibit 7–4
Balance Sheet, Years Ended December 31, Vertical and Horizontal Analysis
Assets 20X1 % 20X0 %

Current Assets:
Cash $ 50,000 2.40% $ 37,989 1.94%
Marketable Securities 116,006 5.57% 50,000 2.56%
Accounts Receivable 247,856 11.90% 224,659 11.49%
Inventories 1,343,670 64.50% 1,308,100 66.92%
Prepaid Expenses 2,247 0.11% 0 0.00%
Total Current Assets 1,759,779 84.47% 1,620,747 82.91%
Fixed Assets:
Property, Plant, and Equipment 860,307 41.30% 803,518 41.10%
Less: Accumulated Depreciation 543,426 26.09% 477,994 24.45%
316,881 15.21% 325,524 16.65%
Other Assets 6,537 0.31% 8,537 0.44%
Total Assets $2,083,197 100.00% $1,954,808 100.00%

Notes Payable—Bank $ 55,000 2.64% $ 85,000 4.35%
Current Portion of
Long-Term Debt 1,850 0.09% 5,553 0.28%
Accounts Payable 642,237 30.83% 535,610 27.40%
Notes Payable—Other 134,692 6.47% 144,692 7.40%
Accrued Expenses 46,980 2.26% 47,913 2.45%
Accrued Income Taxes 10,743 0.52% 16,064 0.82%
Total Current Liabilities 891,502 42.79% 834,832 42.71%
Long-term Debt
Notes Payable—Bank 22,818 1.10% 10,488 0.54%
Less: Current Portion (1,850) 0.09% (5,553) 0.28%
Net Long-Term Debt 20,968 1.01% 4,935 0.25%
Owners’ Equity
10,000 Shares 122,643 5.89% 122,643 6.27%
Retained Earnings 1,070,584 51.39% 992,398 50.77%
1,193,227 57.28% 1,115,041 57.04%
Less Treasury Stock (At Cost) 22,500 1.08% 0 0.00%
1,170,727 56.20% 1,115,041 57.04%
$2,083,197 100.00% $1,954,808 100.00%
Owners’ Equity

For example, using the numbers from Exhibits 7–3 and 7–4, the com-
pany’s inventory turnover for 20X1 is 4.5 times, calculated as follows:
Cost of Goods Sold
Average Inventory
$5,963,510
= 4.5
($1,343,670 + 1,308,100) ÷2
If the industry average for the inventory turnover is 6 times, then the
company, with a turnover of 4.5 times, is not moving its inventory as fast as
the industry average.
Number of Days’ Inventory

The “number of days inventory” ratio is the average number of days a unit is
in inventory. It is computed using the following formula:
365
Inventory Turnover
For example, if a company’s inventory turnover is 4.5 times, then the

number of days in inventory is 81.11 days. If the industry average for the num-
ber of days inventory is 75 days, then the company is holding items in inven-
tory longer than the industry average.
Total Asset Turnover

The total asset turnover ratio reveals how effective a company is at generating
sales from its base of assets. It is an indication of general company efficiency
and is calculated using the following formula:
Net Sales
Total Assets
Exhibit 7–3 shows that the company had net sales of $8,173,780 in 20X1,
and Exhibit 7–1 shows total assets (for 20X1) of $2,083,197, for a total asset
turnover of 3.92 times, calculated as follows:
$8,173,780
÷ 3.92
$2,083,197
If the industry average for the total asset turnover is 2.9, then the com-
pany is squeezing relatively more sales out of its base of assets than the in-
dustry does on average.

3. Using Exhibits 7–2 and 7–5, calculate and evaluate the following for 20X1:
Average Collection Period __________ (Industry Average = 19 days)
Evaluation: ________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
4. Inventory Turnover __________ (Industry Average = 3 times)

Evaluation: ________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
xhibit 7–5
!
Statement of Income, Years Ended December 31
20X1 20X0
Sales $8,172,669 $7,341,704
Gross Profit 2,211,381 2,152,389
Operating Expenses
Selling and Administrative 1,990,721 1,887,420
Interest 12,915 29,966

Profit Before Taxes 146,796 204,037
Provision for Taxes 62,500 87,000
Net Income 84,296 117,037

Leverage Ratios
Management has a choice between two sources of financing for the company—
debt and equity. Of the two choices, debt carries the greatest risk, since its cost
is fixed and contractual. However, debt financing has an important advantage;
in good times (rising revenues), the cost of debt is limited to the interest pay-
ments, whereas the cost of equity is variable. The use of debt to finance a firm
is called leverage because of the potential to “leverage” earnings by using debt.
Leverage ratios help the analyst forecast the solvency of the firm in the
long run. They give long-term debt-holders an indication of the protection
available to them, as well as indicating to equity holders/investors how secure
their returns may be. If more debt is added to a firm’s structure, the return on
common stock may be reduced or less certain.
The following ratios may be used by analysts in their examination of a
company’s use of leverage:
• Debt ratio
• Debt-to-equity ratio
• Times interest earned
Debt Ratio
The debt ratio is also called the total-debt-to-total-assets ratio. It is a measure of
the degree to which assets would be needed to settle claims by creditors if a
company had to liquidate its assets. It could also be viewed as the percentage
of assets financed by debt. The debt ratio is calculated as follows:
Total Debt
Total Assets
Using the 20X1 figures from Exhibit 7–1, the company’s debt ratio is 43.80
percent ($912,470 ÷ $2,083,197). If the industry debt ratio is 45 percent, you
could say that the company is using comparable levels of debt to finance assets.
Debt-to-Equity Ratio
The debt-to-equity ratio shows the stake that creditors have in the business
in relation to the owners’ investment. If a company has a debt-to-equity ratio
that is comparatively lower than the industry average, that company’s credi-
tors’ demands are probably not of great concern to management. However, a
comparatively high debt-to-equity ratio is of great concern to management,
since it means that creditors’ demands could impact its freedom. The debt-
to-equity ratio is computed as follows:
Total Liabilities
Total Owners’ Equity
Using Exhibit 7–1 as an example, the company’s debt-to-equity ratio for
20X1 is 77.94 percent, calculated as follows:
$912,470
$1,170,727 = 77.94 percent

If the industry average for debt-to-equity ratio is 80 percent, then the

company is feeling about the same amount of debt pressure as does the in-
dustry on average. A very small debt-to-equity ratio may not be good for a
company, since prudent use of debt, with its fixed cost, can help a company
achieve a greater rate of return than when the debt is not used.
Times Interest Earned

The times-interest-earned ratio measures the company’s ability to meet in-
terest payments. It is an indication of the company’s margin of safety, showing
the ability of earnings to pay interest on debts. The ratio discloses the number
of times that earnings could cover the interest expense of the company. A rel-
atively high times-interest-earned ratio is preferable to a low ratio. Using the
20X1 numbers from Exhibit 7–3 as an example, the times-interest-earned
ratio is 11.88 times, calculated as follows:
Income Before Taxes and Interest Charges
Interest Charges
$154,712
$13,026 = 11.88
If the industry average is 10, then the company with an 11.88 times in-
terest earned ratio is in good shape.
5. Using Exhibits 7–2 and 7–5, calculate and evaluate the following for 20X1:
Debt-to-Equity Ratio __________ (Industry Average = 65 percent)
Evaluation: ________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
6. Times-Interest-Earned Ratio __________ (Industry Average = 10 times)

Evaluation: ________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

VERTICAL AND HORIZONTAL ANALYSIS

Another useful tool for spotting trends is vertical and horizontal analysis. This
is accomplished by determining what each item on the financial statement is
as a percentage of a given base. The base is usually total assets in the case of
the balance sheet, and net sales in the case of the income statement. Horizontal
analysis compares percentages across periods, whereas vertical analysis com-
pares them within the period. We can use the data set out in Exhibit 7–4 to
illustrate vertical and horizontal analysis. For example, a horizontal analysis
of inventories shows that inventory was 66.92 percent of total assets in 20X0,
but only 64.50 percent in 20X1. This comparison is made by looking horizon-
tally across the years of the balance sheet. Vertical analysis is just the opposite.
It involves looking up and down the columns of the balance sheet and making
comparisons. For example, in 20X1, inventory at 64.5 percent of total assets
is by far the greatest component of assets, with accounts receivable (at 11.90
percent) being the next-largest asset element.
A further horizontal and vertical analysis of Exhibit 7–4 reveals that the
company has apparently improved in a few areas. The cash and marketable
securities have increased, while inventories have gone down. This makes the
company more liquid, which is also seen in the increase in current assets as a
percentage of the total.
On the liability side, the decrease in notes payable has been offset by the
increase in the accounts payable. The company has switched bank debt for
trade debt.
7. What trends do you spot by examining the balance sheet in Exhibit 7–6?
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________


xhibit 7–6
Balance Sheet, Years Ended December 31
Assets 20X1 % 20X0 %

Current Assets:
Cash 100,000 5.26% 37,989 1.94%
Marketable Securities 75,000 3.94% 50,000 2.56%
Accounts Receivable 257,856 13.56% 224,659 11.49%
Inventories 1,143,670 60.12% 1,308,100 66.92%
Prepaid Expenses 2,247 0.12% 0 0.00%
Total Current Assets 1,578,773 83.00% 1,620,747 82.91%
Fixed Assets:
Property, Plant, and
Equipment 860,307 45.23% 803,518 41.10%
Less: Accumulated
Depreciation 543,426 28.57% 477,994 24.45%
316,881 16.66% 325,524 16.65%
Other Assets 6,537 0.34% 8,537 0.44%
Total Assets $1,902,191 100.00% $1,954,808 100.00%

Current Portion of
Long-Term Debt 1,850 0.10% 5,553 0.28%
Accounts Payable 542,237 28.51% 535,610 27.40%
Notes Payable—Other 104,692 5.50% 144,692 7.40%
Accrued Expenses 46,980 2.47% 47,913 2.45%
Accrued Income Taxes 10,743 0.56% 16,064 0.82%
Total Current Liabilities 731,502 38.46% 834,832 42.71%
Long-term Debt
Less: Current Portion (1,850) !0.10% (5,553) !0.28%
Net Long-Term Debt 120,968 6.36% 4,935 0.25%
Owners’ Equity
10,000 Shares 122,643 6.45% 122,643 6.27%
Retained Earnings 949,578 49.92% 992,398 50.77%
1,072,221 56.37% 1,115,041 57.04%
Less Treasury Stock
(At Cost) 22,500 1.18% 0 0.00%
1,049,721 55.18% 1,115,041 57.04%
Owners’ Equity $1,902,191 100.00% $1,954,808 100.00%

Financial analysis can help you gain a better understanding

of the financial strengths and weaknesses of a firm. Although
financial analysis can take many forms, financial ratio analysis
is one of the tools most commonly used.
Three categories of financial ratios were examined in this
chapter: liquidity, activity, and leverage. Liquidity ratios help
the user understand the company’s ability to pay its bills. The
current ratio and the quick (acid-test) ratio are commonly
used to judge liquidity. Activity ratios measure how efficiently
the company manages its assets. Examples of activity ratios include accounts
receivable and inventory turnover, average collection period, number of days
inventory, and total asset turnover. Leverage ratios measure debt burden. The
debt ratio, debt-to-equity ratio, and times-interest-earned ratio are three pop-
ular leverage ratios that help financial statement users monitor the long-term
solvency of a business.
Another technique to analyze the balance sheet is using vertical and hor-
izontal analysis. By calculating balance sheet items as a percentage of assets
and comparing results from year to year, trends can be recognized that can’t
always be seen from a first glance at the numbers.

Review Questions
1. The following formula is for the ____ ratio: 1. (b)

(Cash + Marketable Securities + Net Receivables)
Current Liabilities
(a) current ratio
(b) quick ratio
(c) debt ratio
(d) solvency ratio
2. Which of the following best describes the difference between the 2. (c)
current ratio and the quick ratio?
(a) The current ratio allows one-half of fixed assets to be considered
as a liquid asset whereas the quick ratio only considers current
assets as liquid.
(b) The current ratio uses current fair market values whereas the
quick ratio uses liquidation values for current assets.
(c) The quick ratio does not include inventory in the nominator of
the ratio whereas the current ratio does.
(d) The quick ratio includes long-term investments at their fair
market value whereas the current ratio does not.
3. Which ratio is this? 3. (c)
Cost of Goods
Sold Average Inventory
(a) Number of days inventory
(b) Average collection period
(c) Inventory turnover
(d) Total asset turnover
4. Which of the following ratios measures the stake that creditors have 4. (a)
in the business in relation to the owners’ investment?
(a) Debt-to-equity ratio
(b) Debt ratio
(c) Times interest earned
(d) Total asset turnover
5. If you are using a form of financial analysis that uses a base of total assets 5. (d)
in the case of the balance sheet, and net sales as a basis of comparison in
the case of the income statement, you would most likely be working with:
(a) the current ratio.
(b) the quick ratio.
(c) the acid test ratio.
(d) vertical and horizontal analysis.


1&2. Current Ratio = 2, which is equal to the industry average and therefore an
acceptable ratio. Quick Ratio = 0.6, which is below the industry average. This
means that the firm’s liquidity is less than that of its peers in the industry (on
average) and therefore needs improvement. The lower-than-average quick ratio,
in tandem with an average current ratio, may point to a relatively large investment
(in relation to industry averages) in inventory.
3&4. Average collection period = 10.5 days, as compared to the industry average of 19
days, means that the firm is collecting receivables faster than does its peers in the
industry. Inventory turnover of 4.88 times, as opposed to an industry average of 3
times, is favorable, since it means that the firm is “turning over” its inventory faster
than does its peers in the industry.
5&6. A debt-to-equity ratio of 73 percent, as compared to the industry average of 65
percent, means that the firm uses relatively more debt to finance its operations
than do its peers in the industry. A times-interest-earned ratio of 12.36 times is
favorable, in comparison with the industry average of 10 times. Because the firm’s
times-interest-earned ratio is greater than the industry average, you can conclude
that the firm has a larger safety cushion to cover its interest charges with earnings
than its peers.
7. The liquidity position of the company has improved with cash, marketable
securities, and accounts receivable equaling 22.75 percent of assets in 20X1, as
opposed to 15.99 percent in 20X0. In addition, the company’s current assets as a
percentage of total liabilities and equity decreased from 42.75 percent in 20X0 to
38.46 percent in 20X1. However, long-term debt increased from .25 percent to 6.36
percent during that same period.

Income Statement Analysis
8
Learning Objectives
to:
• List the three elements of every sales dollar.
• Identify the elements to be analyzed in the
gross profit ratio.
• List the profitability ratios.
• Discern income trends using vertical and
horizontal analysis.
SALES
Analysis of the income statement begins with sales, or more specifically, net
sales. Net sales are equal to gross sales, less returns and allowances or discounts.
Gross sales must not be used as the basis for percentage and ratio calculations
because the amount of sales returns and allowances may be significant.
Every sales dollar is made up of three basic components: cost of goods sold,
operating expenses, and net income or loss. Note: If net income is zero (break-even),
then the sales dollar will have two elements—cost of goods sold and operating
expenses.
COST OF GOODS SOLD

The cost of goods sold, sometimes called cost of sales, is generally the most sig-
nificant cost as a percentage of sales in the income statement. Cost of goods
sold is a relatively simple computation. The following formula shows the
111
calculation for a merchant—a retailer or wholesaler:

Cost of Beginning Inventory + Net Purchases −
the Cost of the Ending Inventory = Cost of Goods Sold
Net purchases are calculated this way:

(Purchases for the Period − Purchase Discounts) −
Purchase Returns and Allowances] + Freight Charges = Net Purchases
The cost of goods sold in a manufacturing company is a bit more complex.

Instead of net purchases, another calculation is performed called cost of goods
manufactured. That calculation takes into account the purchases during the
period and the changes in the work-in-process account. Here is the basic for-
mula for cost of goods sold for a manufacturing company:
Beginning Finished Goods Inventory + Cost of Goods Manufactured
During the Period − Ending Finished Goods Inventory
1. Use the following numbers to compute the cost of goods sold for 20X1 for a retailer:
Inventory, January 1, 20X1 $200,000
Inventory, December 31, 20X1 $250,000
Purchases During 20X1 $300,000
Purchase Returns and Allowances During 20X1 $20,000
Purchase Discounts During 20X1 $10,000
Freight Charges on Purchases During 20X1 $11,000
Cost of Goods Sold $ _______
2. Use the following information to calculate the cost of goods sold for 20X1 for a manufacturer:
Finished Goods Inventory, January 1, 20X1 $200,000
Finished Goods Inventory, December 31, 20X1 $250,000
Cost of goods Manufactured During 20X1 $300,000
Purchases $20,000
Cost of Goods Sold $ _______
Gross Profit
The excess of sales over cost of goods sold is called gross profit. The calculated
percentage (amount of gross profit divided by net sales) is often used as an
operating ratio, called gross-profit-margin ratio or gross profit ratio.

INCOME STATEMENT ANALYSIS 113
Changes in the gross profit ratio should be analyzed in detail for:

• The quantity of units of product sold
• The changes in selling prices
• The cost of goods sold in terms of units of the different types of product
(product mix)
• Changes in costs
In multi-product companies, sales mix is very important in calculating a

gross profit amount or ratio. Variations in gross profit between the periods
under study may occur because of increases or decreases in sales volume, unit
cost, unit selling price, or a combination of these factors.
Analysis of Trends of Net Sales, Cost of Goods Sold, and Gross Profit
The gross profit and the gross profit ratio can give an early indication of a
company’s profitability. Analysis of trends in net sales, cost of goods sold, and
gross profit can provide additional information. Exhibit 8–1 shows an example
of how trends can tell a story about the profitability of a company.
Exhibit 8–1 shows a four-year trend of sales, cost of sales, and gross profit
for a company. With 20X1 as a base period, the following have been com-
puted:
• Net sales trend percentage
• Cost of goods sold trend percentage
• Cost of goods sold as a percentage of sales
• Gross profit ratio
Notice in Exhibit 8–1 that although the net sales trend percentage for
20X4 is up 46 percent from the 20X1 level (20X4 is 146 percent of the 20X1
level), the cost-of-goods-sold-trend percentage is also up—57 percent (20X4
level is 157 percent of 20X1), resulting in a shrinking gross profit ratio of 40.9
percent in 20X4, down from its 20X1 level of 45 percent. This means that al-
though the gross profit dollar amount is moving upward, the company is less
profitable because cost of goods sold is increasing relative to sales, and the
gross profit ratio is in a downward trend.
Operating Expenses
The gross profit is a preliminary profit from which operating expenses are sub-
tracted. If management exercises any significant control over costs and expenses,
it is usually in the area of operations. Operating management is mainly respon-
sible for the day-to-day activities that produce revenue, and results should re-
flect the company’s ability to adjust expenses to the fluctuation of sales.
Analysis of operating expense components and trends may be of some
value to financial management. Exhibit 8–2 shows an analysis of the compo-
nents and trends of the operating expenses of a company. The individual op-
erating expense ratios are shown as percentages of net sales, and reflect how
much of the revenue has been consumed by various operating expenses. These
ratios and percentages can also gain greater meaning when compared with
those of similar businesses or the industry as a whole.

xhibit 8–1

Trends: Comparison of Net Sales, Cost of Goods Sold, and Gross Profit
20X1 20X2 20X3 20X4

Net Sales $119,600 $144,100 $161,700 $174,400
Trend Percentage 100 120 135 146
Cost of Goods Sold $ 65,700 $ 83,600 $ 95,100 $103,000
Gross Profit $ 53,900 $ 60,500 $ 66,600 $ 71,400
Gross Profit Ratio 45.07% 41.98% 41.19% 40.94%
In Exhibit 8–2, the four-year sales trend shows a 42 percent increase,

!
while expenses increased by 93 percent.
OPERATING INCOME
Operating income is the end result of the buying, manufacturing, and selling
activity of a business. It is the total profit available after normal operating ex-
penses have been deducted from gross profit but before interest income, div-
idend income, interest expense, and extraordinary and nonrecurring income
and expenses have been added or deducted. Operating income is the basis for
evaluating the profitability of operations. It is calculated as follows:
Operating Income = Gross Profit – Operating Expenses
xhibit
8–2

Comparative Statement of Operating Expenses
20X1 20X2 20X3 20X4

$ % $ % $ % $ %
Sales Salaries 32.4 5.1 35.0 5.2 36.5 4.9 46.1 5.1
Salesperson Travel 7.0 1.1 8.1 1.2 12.7 1.7 19.0 2.1
Advertising 14.7 2.3 20.9 3.1 26.8 3.6 38.0 4.2
Depreciation: Equipment 12.1 1.9 14.9 2.2 20.1 2.7 29.0 3.2
Maintenance and Repair 14.0 2.2 18.2 2.7 23.8 3.2 35.3 3.9
Office Salaries 23.6 3.7 27.7 4.1 29.1 3.9 32.6 3.6
Total Expenses 103.8 16.3 124.8 18.5 149.0 20.0 200.0 22.1
Expense Trend 100.0 120.2 143.5 192.7
Net Sales 637.0 675.0 745.0 905.0
Sales Trend 100.0 106.0 117.0 142.0

PROFITABILITY RATIOS
Profitability ratios can be used to assess a company’s ability to control ex-
penses and to convert sales into profits. In addition, profitability ratios help
determine how effectively the company produces profits from its resources.
We present six profitability ratios in the sections that follow:
• Gross profit margin
• Operating profit margin
• Profit margin
• Return on assets
• Return on equity
• Earnings per share
We will use the 20X1 numbers from the balance sheet and income state-
ments in Exhibits 7–1 and 7–3 to explain each of the profitability ratios.
Gross Profit Margin

The gross profit margin shows the percentage of revenue or sales left after
subtracting the cost of goods sold. A company that boasts a higher gross profit
margin than its competitors and the industry average is doing a good job pric-
ing its product and controlling its cost of goods (or cost of goods manufac-
tured). It is calculated as follows:
Gross Profit Margin = Gross Profit ÷ Net Sales (Revenues)
.27 or 27% = $2,210,270 ÷ $8,173,780
Operating Profit Margin

The operating profit margin shows the percentage of revenue or sales left
after subtracting cost of goods sold and operating expenses. A company that
has a higher operating profit margin than its competitors and the industry av-
erage is doing a good job controlling operating costs and/or maintaining a
solid gross profit margin. It is calculated as follows:
Operating Profit Margin = Profit from Operations ÷ Net Sales (Revenues)
.0165 or 1.65% = $135,257 ÷ $8,173,780
Profit Margin
The profit margin shows the percentage of net income produced by each sales
dollar. Using the income statement from Exhibit 7–3, the profit margin for-
mula is:
Profit Margin = Net Income after Taxes ÷ Net Sales =
$78,186 ÷ $8,173,780 = 0.96 percent
The industry profit margin is 1.20 percent. The company profit margin
of .96 percent means that the company is less profitable than its peers.

Return on Assets
The return on assets ratio measures how efficiently the company uses its total
resources (total assets) to produce net income. Using Exhibits 7–1 and 7–3,
return on assets is computed as:
Return on Assets = Net Income after Taxes ÷ Average
Total Assets = $78,186 ÷ $2,019,002 = 3.87 percent
If the industry average is 3.5 percent, then the company is more efficient
than its peers in squeezing profits from its resources.
Return on Equity
The return on equity measures the rate of return earned on the owners’ in-
vestment in the company (as measured by equity). It is a ratio that an investor
would be interested in watching, since the value of the investment could in-
crease if the return on equity improves. Again using Exhibits 7–1 and 7–3,
the return on assets is computed as:
Return on Equity = Net Income after Taxes ÷ Average
Owners’ Equity = $78,186 ÷ $1,142,884 = 6.84 percent
If the industry average is 6.3 percent, then the company is, on average,
providing a greater return on owners’ equity than its peers.
Earnings per Share

Earnings per share is also a measure of profitability that is important to the
owners. It is a simple computation used when there is a single class of stock:
net income divided by the number of outstanding shares. (Care must be taken
when more than one class of stock is authorized and issued because the exis-
tence of preferred stock will dilute the earnings per share of common stock.
Other items that might reduce earnings per share of common stock are: con-
vertible securities, stock options, and warrants. The example given here covers
only common stock.) Earnings per share tells you how much income “stands
behind” each share of stock—an important concept, since it is from earnings
that dividends are paid to owners.
Earnings per Share = Income Available to Common Stockholders
Weighted-Average Number of Common Shares Outstanding for the Period
If you assume that a company has net income of $98,186 and pays its pre-
ferred stockholders $20,000, the income available to common stockholders
would be $78,186. If the weighted-average number of shares is 10,000, then
the earnings per share would be $7.82, as shown below.
EPS = $78,186 ÷ 10,000 = $7.82
Diluted EPS reflects the potential dilution that could occur if securities
or other contracts to issue common stock were exercised or converted into

common stock or resulted in the issuance of common stock that then shared
in the earnings of the entity. Diluted EPS is a more advanced topic that is be-
yond the scope of this course, but it should be recognized as a more conser-
vative indication of the earnings that “stand behind” each share of a company’s
common stock.
3. Using Exhibits 7–2 and 7–5, calculate and evaluate the following:
Profit Margin _____________ (Industry Average = .85 percent)
Evaluation:
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
Return on Assets _____________ (Industry Average = 5.0 percent)
Evaluation:
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
Return on Equity _____________ (Industry Average = 7.5 percent)
Evaluation:
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
4. Using the net income for 20X0 from the income statement in Exhibit 7–5, and assuming 10,000
shares of outstanding common stock, what are the earnings per share for 20X0?

Ratio analysis has its limitations. It doesn’t measure nonfinancial factors such
as the “value” of human resources, a firm’s reputation, or any competitive ad-
vantages the company enjoys. Ratios can be easily calculated from financial
statements, but even though accounting rules (GAAP) promote consistency
from period to period, assumptions and methods can be changed, and ratios

' '
xhibit 8–3
Income Statement
20X1 20X0
$ % $ %
Sales $8,173,780 100.00% $7,341,704 100.00%
Cost of Goods Sold 5,963,510 72.96% 5,189,315 70.68%
Gross Profit 2,210,270 27.04% 2,152,389 29.32%
Operating Expenses;
Selling and Administrative 1,994,054 24.40% 1,887,420 25.71%
Depreciation 67,933 0.83% 66,575 0.91%
Interest 13,026 0.16% 29,966 0.41%
Total Operating Expenses 2,075,013 25.39% 1,983,961 27.02%
Profit from Operations 135,257 1.65% 168,428 2.29%

Other Income 6,429 0.08% 35,609 0.49%
Profit Before Taxes on Income 141,686 1.73% 204,037 2.78%
Provision for Taxes on Income 63,500 0.78% 87,000 1.19%
Net Income $ 78,186 0.96% $ 117,037 1.59%
'
are sensitive to those changes. Companies that have been accused of “window
dressing” make their ratios look better than they should look. Differences in
accounting assumptions used by competitors may make it difficult to compare
ratios from different organizations. Keep in mind that accounting assumptions
include the choice of inventory methods such as last in, first out or first in,
first out and depreciation methods like straight-line or double-declining bal-
ance. Ratios that show significant deviations from industry norms might point
to a company’s strengths or weaknesses, but they also might be indicative of
financial statement fraud or mistakes in the accounting system. However, ra-
tios cannot definitively tell the user whether there is fraud or point to signif-
icant errors, and in some of the largest financial statement fraud cases in
history, financial ratios were not the red flags that brought the fraud to the
surface. In fact, it is usually a “whistle blower” who calls the fraud to the at-
tention of management or the authorities.
HORIZONTAL AND VERTICAL ANALYSIS

Horizontal and vertical analysis is useful for analyzing income statements. For
income statements, this represents setting net sales equal to 100 percent and
then calculating the percentage of net sales for each cost, expense, or other
category.
Exhibit 8–3 shows vertical and horizontal analysis comparing two years.
The results of the analysis show that although sales are up, the gross profit
percentage has dropped by more than two points. Selling and administrative
expenses as a percentage have been reduced, as has interest. Other income

was reduced sharply. The net result of all these changes is that the percentage
of sales of income before taxes was reduced from 2.78 percent to 1.73 percent,
and the percentage of sales of income after taxes was reduced from 1.59 per-
cent to 0.96 percent. This is lower than the average and may be cause for con-
cern. The outside analyst, especially one who represents a lending institution,
will want to be very clear as to why these ratios are performing this way. Is it
a single-year problem, or is it industry wide?
5. Complete the following report by calculating the percentages for both years, then answer the
questions.
a. Has the gross profit percentage improved or deteriorated over the two periods?
Improved Why? ____________________________________________________
Deteriorated Why? ____________________________________________________
b. Within operating expenses, what components have increased proportionally from
period 1 to period 2?
c. 20X1 results do show that the company has produced greater profits over 20X0. How does
20X1 compare to 20X0 based on the profit margin of the two periods?
20X1 20X0
$ % $ %
Sales $13,200,000 100.00% $12,500,000 100.00%
Gross Profit 3,432,000 26.00% 2,750,000 22.00%
Operating Expenses;
Depreciation 91,000 0.69% 89,000 0.71%
Interest 28,000 0.21% 19,000 0.15%
Profit from Operations 1,069,000 8.10% 742,000 5.62%
Other Income 35,000 0.27% 9,000 0.07%
Profit Before Taxes on Income 1,104,000 8.36% 751,000 5.69%
Net Income $772,800 5.85% $600,800 4.55%

The analysis of the income statement begins with an under-

standing of sales. Every sales dollar comprises three basic
components: cost of goods sold, operating expenses, and net
income or loss. Net sales are the true sales for the period, since
net sales take into account returns of product by customers,
allowances (reductions of price or adjustments to invoices)
granted for various reasons, and all discounts granted to credit
customers for early payments.
Financial analysis of the income statement can be facili-
tated by the use of profitability ratios such as the operating ratio, more com-
monly called the gross profit ratio, and the profit margin. Other ratios, such
as return on assets, return on equity, and earnings per share, give additional
insight into how well a company is producing profits from its base of assets
and investor’s equity. All these profit-related ratios need to be monitored over
time by interested parties such as owners, managers, and creditors.
The firm as a profit generator is a complex entity and sometimes difficult
to understand—even when financial ratios are used. Many other considera-
tions come into play when reviewing the profit performance of a company.
Variables such as the quantity of units of product sold, changes in selling
prices, product mix, and cost changes have an effect on the profits of a busi-
ness, and of course, on its profitability ratios.
Vertical and horizontal analysis of income statements can provide addi-
tional information about a company’s profitability. A vertical analysis of fi-
nancial statements shows you the relationships among components measured
as percentages. On a balance sheet, each asset is shown as a percentage of total
assets; each liability or equity item is shown as a percentage of total liabilities
and equity. On the income statement, each line item is shown as a percentage
of net sales.
A horizontal analysis provides you with a way to compare numbers from
one period to the next. Each line item has an entry in a current period column
and a prior period column; and again, percentages help give significance to
differences (changes) between two or more reporting periods.

Review Questions
1. Which expense is generally the most significant cost as a percentage 1. (a)

of sales in the income statement?
(b) Selling expense
(c) Administrative expense
(d) Income tax expense
2. The excess of sales over cost of goods sold is called: 2. (c)

(a) net income.
(b) operating income.
(c) gross profit.
(d) net profit.
3. Profit margin, return on assets, return on equity, and earnings per 3. (b)
share are all:
(a) liquidity ratios.
(b) profitability ratios.
(c) quick ratios.
(d) measures of efficiency.
4. Net Income after Taxes ÷ Net Sales =: 4. (d)

(a) Return on Assets
(b) Return on Equity
(c) Earnings per Share
(d) Profit Margin
5. In performing vertical analysis of an income statement, you 5. (b)

calculate the percentage of ______ for each expense on the
income statement.
(a) assets
(b) net sales
(c) cost of goods sold
(d) net income

122 UNDERSTANDING FINANCIAL STATEMENTS

1. $231,000
2. $250,000 (beginning finished goods plus cost of goods manufactured less ending
finished goods). Do not use the value for purchases, as that would be taken into
account in the cost of goods manufactured.
3. A profit margin of 1.03 percent, as opposed to an industry average of .85 percent, is
favorable. A return on assets of 4.3 percent, as opposed to an industry average of 5
percent, is unfavorable. It appears that the industry is able to squeeze relatively
more profit out of its assets. A return on equity of 7.5 percent is equal to the
industry average.
4. $11.70
5. 20X1 20X0
$ % $ %
Sales $13,200,000 100.00% $12,500,000 100.00%
Gross Profit 3,432,000 26.00% 2,750,000 22.00%
Operating Expenses;
Depreciation 91,000 0.69% 89,000 0.71%
Interest 28,000 0.21% 19,000 0.15%
Profit from Operations 1,069,000 8.10% 742,000 5.62%

Other Income 35,000 0.27% 9,000 0.07%
Profit Before Taxes on Income 1,104,000 8.36% 751,000 5.69%
Net Income $772,800 5.85% $600,800 4.55%
a. It has improved as the cost of goods sold as a percentage of sales have fallen.
b. Selling and administrative expenses and interest expense have increased
proportionately to sales whereas depreciation expense has decreased as a
percentage of sales.
c. The profit margin has also increased (20X1 is 5.85% versus 20X0 of 4.55%).

Analysis of
9
Operational Results
Learning Objectives
to:
• List the three kinds of costs.
• Explain the term break-even point.
• List three uses of break-even analysis.
• Define the term contribution margin.
• Identify the five factors that influence cost-
volume-profit analysis.
INTRODUCTION
One’s objective in managing a business is described simply in this way: to assure
that the benefits achieved exceed the sacrifices made. Managers are constantly faced
with decisions about selling prices, variable and fixed costs, choice of product
lines, market strategy, utilization of production facilities, and acquisition and
employment of economic resources in pursuit of some goal or objective. The
bases for financial planning and control include cost-behavior analysis, eval-
uation of cost-volume-profit relationships, and flexible budgeting. Flexible
budgeting allows the effect of changes in anticipated volume to be taken into
account and involves a series of budgets for varying levels of activity. Many
managers are interested in cost behavior, cost control, and cost measurement.
This chapter presents information that will aid in their planning and control.
123
COST BEHAVIOR
The first basis for planning and control, cost behavior, refers to the degree of
responsiveness a cost has at various activity levels. There are fixed costs, vari-
able costs, and mixed costs.
Fixed Costs
Fixed costs remain unchanged within a relevant range of activity. If straight-
line depreciation is used for fixed-asset write-off, the cost is fixed and un-
changing for a specific, short time period. Reference to a particular time
period is essential to the concept of a fixed cost because all costs tend to be
variable over a long period of time. For consistency, the time frame used in
this text is one year.
Although the fixed cost will have the same total, the unit rate changes
inversely with volume. For example, assume annual depreciation of $100,000,
using the straight-line method. This amount is charged as a cost, regardless
of the level of production or sales. At the 100,000-unit level of production,
the depreciation rate per unit is one dollar. If 200,000 units were produced,
the rate would reduce to 50 cents per unit. Since the fixed cost depends on a
particular volume, these amounts will remain constant within a workable
range. Supervisors’ salaries provide a good illustration. A supervisor’s salary
is fixed, regardless of whether the group of people he or she supervises con-
sists of 20 or 40 people (or any number in between).
Variable Costs
Variable costs, in total, change in direct proportion to an activity level. Total
variable costs of a particular cost object (something that you are tracking the
cost of) increase with increases in the volume level related activity and de-
crease with decreases in the volume level of the related activity. For instance,
the total cost of raw material used in production varies in relation to the num-
ber of units produced. Thus, if a unit of material costs $5, this rate will not
change, regardless of the number of units used in production; but the total
cost increases directly with the number of material units used in production.
Mixed Costs
Mixed costs are a hybrid cost—part fixed and part variable. For example, a cell
phone bill could be a mixed cost if it has a fixed monthly fee plus a rate per
minute of usage. Operating company vehicles is a classic example of a mixed
cost involving certain fixed costs such as annual insurance and variable costs such
as changing fuel prices and differing amounts of use from one month to another.
The algebraic formula for a mixed cost is y = a + bx, where:
y is the total cost
a is the fixed cost per period
b is the variable rate per unit of activity
and x is the number of units of activity

ANALYSIS OF OPERATIONAL RESULTS 125
For example, the annual expense of operating a truck might be found

using the following formula:
$5,000 + .30x
Where x is the number of miles driven (the activity).

If the truck is driven 20,000 miles in a particular year, the cost would be:
$5,000 + .3(20,000) = $11,000
COST-VOLUME-PROFIT ANALYSIS
The cost-volume-profit (CVP) analysis in this chapter covers only variable
and fixed expenses. Exhibit 9–1 shows the relationship of total costs to unit
costs at various levels of production. If the total fixed cost remains the same,
the cost per unit decreases as volume increases. The total variable cost in-
creases directly with an increase in production, but the rate of increase is con-
stant.
Five important factors influence cost-volume-profit analysis. They are:
1. Fixed costs
2. Variable costs
3. Selling prices of products
4. Volume of sales or level of sales activity
5. Mixture of the types of products sold
All of these factors must be weighed by management when engaging in

profit planning and cost control.
Break-Even Point
The study of cost-volume-profit analysis, often called break-even analysis,
stresses the relationship among the five elements listed above. The break-even
point is the point where the volume of sales or level of operations produces
neither a net income nor a net loss. In other words, the break-even point is
where revenues will just cover costs. This point can be found mathematically
xhibit 9–1
A Comparison of Total Costs with Unit Costs at Various Levels of Production
Production in Units 1,000 2,000 3,000 4,000

Total Cost:
Fixed $5,000 $ 5,000 $ 5,000 $ 5,000
Variable 7,000 14,000 21,000 28,000
Unit Cost:
Fixed $5.00 $2.50 $1.67 $1.25
Variable 7.00 7.00 7.00 7.00

or by preparing a graph. Whichever method is used, all costs are separated

into fixed and variable categories.
Working with an example is the best way to understand the break-even
point calculation. For example, John Smith is a college student who earns his
tuition by doing odd jobs and taking on small business ventures. He plans on
selling historical plaques during a Fourth of July picnic. He purchases the
plaques for $2 each, retaining the option to return all unsold items. The rental
of his booth costs $150. If the plaques sold for $5 each, how many would John
have to sell in order to break even? (Ignore income taxes.)
In determining the break-even point using a mathematical computation,
you must understand the most elementary formula for computing a break-
even point:
Break-Even Sales = Variable Cost + Fixed Cost
If you let X = sales at break-even (units of dollars), you can plug John
Smith’s data into the equation as follows:
$5X = $2X + $150
3X = 150
X = 50 plaques
Proof:
Sales = 50 plaques @ $5 each = $250
Cost and Expenses—Variable:

50 Plaques @ $2 each = $100
Fixed:
Rent: $150 $250
Profit: $0
What would John’s profit be if he sold 51 plaques? Quite often, people

assume the answer is $5. But calculation is necessary to be sure.
Sales = 51 plaques @ $5 each = $255

51 Plaques @ $2 each = $102
Fixed:
Rent: $150 $252
Profit: $3

The cost of the plaques fluctuates directly with the quantity purchased—
a variable cost. Fixed cost is recovered with the sale of the first 50 plaques.
Thereafter, the sale of each plaque contributes to profit, after covering the
variable cost per unit.
By expanding on the basic formula, it can be determined how many
plaques must be sold to earn a particular profit. Suppose John Smith wanted
to earn $75 for the period of time he spends in his booth. The formula would
be expanded to solve for the $75 profit as follows:
Sales = Variable Cost + Fixed Cost + Profit
$5X = $2X + $150 + $75
3X = 225
X = 75 plaques
Proof:
Sales = 75 plaques @ $5 = $375

75 plaques @ $2 = $150
Fixed:
Rent: $150 $300
Profit: $75
1. Compute the monthly break-even point for a company that has variable cost of $4 per unit and
monthly fixed costs of $600. The company’s sales are $10 per unit.
2. Using the facts in question 1, what would the volume of sales need to be to achieve a profit of
$1,000 in one month?
THE GRAPHIC PRESENTATION OF

BREAK-EVEN
A break-even point graph can be used to determine the dollar or unit amount
at which there will be no profit or loss. Exhibit 9–2 plots John Smith’s infor-
mation. Although the graph is not accurate decimally, it is adequate for the
limited range used here.

The sales and total expense lines cannot be plotted ad infinitum with the
hope of maximizing profit to the nth degree. A saturation point will be reached
where sales begin to drop or where both fixed and variable costs begin to in-
crease. Here the lines on the graph cross each other again; the area beyond
the second juncture is a loss area.
Sales may begin to slow down because there are fewer buyers in the mar-
ket who want to purchase. On the other hand, costs and expenses may begin
to climb because the scarcity of material may cause prices to rise, or because
the labor supply may have been reduced to a level that necessitates offering
a monetary incentive to obtain the required work force.
USING BREAK-EVEN ANALYSIS

The break-even point is helpful to management for forecasting, evaluating
managerial efficiency, and decision making. As a forecasting tool, the break-
even point can aid in determining the following:
• The requirements of the sales department that justify a proposed invest-
ment in plant expansion
• The effect of increases and decreases in sales volume
xhibit 9–2
John Smith’s Break-Even Point Graph, July 4, 20X0

• The probable cost per unit of manufactured goods at various production

levels
• The evaluation of changes in production methods
• The planning of profit objectives
Managerial efficiency may be evaluated by comparing actual break-even

results with predetermined levels. If properly considered by management, the
break-even point and the analysis of cost-volume-profit can be valuable tools
when used in conjunction with the analysis of sales mix and the conversion
of variable costs to fixed costs. For example, management may be considering
a capital expenditure in order to automate equipment. This decision would
shift some costs from variable to fixed, thus changing the break-even point.
CONTRIBUTION MARGIN
The contribution margin is most easily defined as the difference between sales
and variable costs. The excess of sales over variable costs can be used to con-
tribute toward meeting fixed costs and achieving a profit for the period. A
comparison of contribution margin and the traditional income statement, and
how they each arrive at net income, is shown in Exhibit 9–3. The contribution
margin is employed by management because costs are classified by behavior
(variable or fixed) rather than by function (production, sales, or administra-
xhibit 9–3
The Traditional Format Income Statement versus the Contribution
Margin Format (000’s omitted)
Traditional Format:
Sales $650
Cost of Goods Manufactured 193
Gross Profit $457
Selling Expenses 224
Administrative Expenses 193
Net Income $ 40
Contribution Margin Format:
Sales $650
Variable Costs and Expenses:
Manufacturing 130
Selling 148
Administrative 112
Contribution Margin $260
Fixed Costs and Expenses:
Manufacturing 63
Selling 76
Administrative 81
Net Income $ 40

tion). It should be noted, however, that contribution margin is not the same
as gross margin or gross profit, which is computed in the traditional format.
Once again, the John Smith venture can illustrate the contribution margin
approach.
Sale price per plaque ($5) − Variable cost per plaque ($2) =
Unit Contribution Margin ($3)
Since the contribution margin of $3 will cover fixed costs, the next ques-
tion is: How many units must be sold to cover the $150 rental with no antic-
ipated profit?
Fixed Costs ($150)

= 50 Units
Unit Contribution Margin in Dollars ($3)
The calculation for the break-even point in dollars, using the contribu-
tion margin, requires a contribution percentage. In Smith’s venture, 60 percent
($3 out of $5) of the total selling price is contributed toward fixed costs and
profit. Since profit does not enter into the calculation of the break-even point,
the dollars of sales needed are:
Fixed Costs ($150)

= $250
Contribution Margin Ratio (0.60)
The contribution margin computation for the $75 profit desired by Smith
is:
Fixed Costs ($150) + Desired Profit ($75)

= $375
Contribution Margin Ratio (0.60)
Fixed Costs ($150) + Desired Profit ($75) = $375 Contribution Margin

Ratio (0.60)
3. Based on the following facts, what is the contribution margin per unit?
A company has variable cost of $5 per unit and monthly fixed costs of $800. Its sales are $15
per unit.


4. Using the contribution-margin approach, compute the monthly break-even point for a company
that has variable cost of $7 per unit and monthly fixed costs of $4,900. The company’s sales
are $14 per unit.
5. Using the same facts as in question 4, what level of sales are needed to produce a $500 profit
in one month?
Advantages of Cost-Volume-Profit Analysis

Cost behavior patterns offer valuable insights into planning and controlling
long-term and short-term operations. It is obligatory that management be-
come fully cognizant of cost-volume-profit analysis. Management’s duty is to
discover the combination of fixed and variable costs that will be most benefi-
cial to the company. A firm that has a large and highly salaried sales force
(fixed cost) may discover through the contribution margin that, after deduct-
ing variable costs from sales, there is an insufficient remainder to contribute
toward fixed costs and profit. It may be less costly for the company to employ
manufacturers’ representatives and compensate them using commission, a
variable cost. Remuneration would then vary directly with sales.
When management sets a profit goal for a specific period of time (annual,
semi-annual, quarterly), it is easy to compute the number of units that must
be sold in order to reach the goal; this is done simply by dividing the fixed
costs plus desired profit by the contribution margin per unit. When the con-
tribution margin is low, a large increase in sales must occur in order to produce
a significant increase in profit. Another look at Exhibit 9–2 reveals that, as
sales move beyond the break-even point, the contribution margin ratio in-
creases and thus profits also increase at a faster rate.
The external analyst may be unable to project future break-even points
at various sales volumes because he or she does not ordinarily have access to
data that are exact enough. Nevertheless, the analyst’s conclusions, although
rough at best, are meaningful. The variable costs may be difficult to project,
but conclusions on fixed costs should be within the limits of company toler-
ance. Although shortcomings in cost-volume-profit analysis do exist, and the
analysis does require laborious effort, performance evaluation is less difficult
given the results of such an analysis.

Limitations of Cost-Volume-Profit Analysis

The function of profit projection is vitally important to financial analysts, but
it is not without its shortcomings. Clear assignment of costs to either a fixed
or variable category is not always possible. The interpretations of several an-
alysts will probably differ. For example, machinery rent that is based on units
produced can be classified as a variable cost when production fluctuates. How-
ever, if production is steady for a period of time beyond the predetermined
range, some analysts may think of the rent as a fixed cost. This differentiation
is often difficult for the internal analyst to determine. For the outside analyst,
categorization is an almost impossible task if he or she does not possess a con-
siderable amount of internal data.
Direct labor is usually classified as a variable cost. Any change in pro-
duction volume will have a direct effect on labor in the same direction. If
management decides on a temporary shutdown of operations, the effect on
the variability of labor cost may not correspond directly. If, for example, the
company wishes to retain its highly experienced and skilled personnel during
the shutdown period so as not to lose them, the fluctuating nature of direct
labor is changed.
Another major weakness of cost-volume-profit analysis as a planning or
controlling device occurs in a manufacturing business. The assumption by
the analyst that sales and production volumes will always be the same may be
valid in theory but not in fact. Business is dynamic, and qualifying a specific
cost analysis with the prefatory statement, “other things being equal,” will not
necessarily produce a valid result because “other things” will not be equal.
Analysis covering an extended period of time requires a common de-
nominator for all component periods so that data examined will be equivalent.
Where costs and prices have changed drastically, adjustments based on current
costs and prices produce a more uniform result. Many outside factors must
also be kept in mind, such as strikes, lateral and vertical competition, domestic
and foreign political developments, and natural disasters.
THE PROFIT-VOLUME GRAPH

The profit-volume graph may be used in place of, or along with, the break-
even graph. This form is preferred by many managers who are interested
mainly in a clearer representation of the effect of volume, since only the net
effect of revenue and cost is shown. The graph has a break-even line instead
of a break-even point. Exhibit 9–4 shows the vertical axis, calibrated was profit
above and loss below the break-even line. The horizontal axis shows units of
product.
Plotting a Profit Line

Assume the following data: selling price per unit is $10; variable cost per unit
is $6; and fixed expense amounts to $150,000.

xhibit 9–4
Profit-Volume Graph
The following steps are necessary to plot a profit line on the graph:
1. Fixed expense exists even at zero level of activity; therefore, the fixed-
expense point is located on the vertical axis below the break-even line.
2. A point should now be plotted to indicate the amount of profit at a chosen
level of sales. The level used in Exhibit 9–4 is 100,000 units, or $1,000,000.
3. Expected profits at this level are:
Sales (100,000 units @ $10 each) $1,000,000
Less Variable Costs (100,000 × $6) 600,000
Contribution Margin 400,000
Less Fixed Costs 150,000
Net Profit$ 250,000
This point is plotted on the graph at the intersection of $1,000,000 of sales

and $250,000 of profit. A line is then drawn from this point to connect the
fixed-expense point of $150,000 on the vertical axis. The point at which the
profit line crosses the horizontal break-even line is the break-even point—
37,500 units, or $375,000. The vertical distance between the profit line and the
break-even line reflects the expected profit or loss at a specific volume of sales.
The profit-volume graph is often preferred by management because the
data are presented more simply than those of a break-even chart. It is a con-
venient device that quickly outlines the effect on expected profits caused by
such changing factors as fixed and variable costs, selling prices, and volume
of sales.

The basis of profit planning and control is knowledge of cost

behavior. You must know the difference between a fixed and
variable cost and how to recognize semi-variable or mixed
costs and how they behave with respect to changes in a par-
ticular key activity level, such as sales or production. Company
cost structures are a complex entanglement of fixed and vari-
able costs, and sometimes it is difficult to sort those costs out.
Fixed costs remain unchanged within a relevant range of ac-
tivity. Variable costs increase with increases in the volume
level of related activity and decrease with decreases in the volume level of
the related activity, while semi-variable costs are a combination that falls
somewhere between fixed and variable cost elements.
Cost-volume-profit (CVP) analysis, which has its origins in break-even
analysis, is useful for predicting cost behavior for a company and for planning
production levels to produce a desired profit. It is a decision-making tool for
management and allows you to ask “what-if ” questions and to see the bot-
tom-line impact of changes in prices, volume, and costs. Management can
consider altering any or all of the five factors of CVP when planning. Those
factors are fixed costs, variable costs, selling prices, sales volume (units), and
the sales mix.
The break-even point can be used either in a formula form or a chart to
determine what revenue level is needed to cover all costs exactly. Break-even
points are often shown in business plans, as investors and creditors like to see
what it will take to cover costs.
Break-even analysis can be modified so that the level of revenue needed
to achieve a profit target can be known. Management can set target profit lev-
els and then use the break-even model to determine what volume of sales will
be necessary and what level of costs will need to be incurred to meet profit
goals.
The contribution margin is another useful tool. It is found on a per unit
basis by subtracting variable costs per unit from the price of a product. Total
contribution margin is the difference between total revenue (or sales) and
variable costs. Knowing the contribution margin allows you to quickly com-
pute break-even and “back solve” for the production levels needed to produce
a desired profit.

Review Questions
1. Which of the following statements is generally true about costs? 1. (b)

(a) Fixed costs will increase on a per-unit basis when sales volume
increases.
(b) Total fixed costs will remain the same regardless of changes in sales
volume within a moderate range of activity.
(c) Variable costs will vary on a per-unit cost basis.
(d) Fixed costs per unit will decrease as volume also decreases.
2. If a particular cost element of a company can be estimated using 2. (c)

the following formula it is a ______ cost.
$100 + $4x where x is sales volume in units
(a) fixed
(b) variable
(c) mixed
(d) sunk
3. Sales price less variable cost per unit is: 3. (d)

(a) gross profit.
(b) profit margin.
(c) mark-up.
(d) contribution margin.
4. Direct labor and direct materials are considered: 4. (b)

(a) fixed costs.
(b) variable costs.
(c) manufacturing overhead costs.
(d) sunk costs.
5. If fixed costs are $200,000, contribution margin per unit is $6, and 5. (a)
the target profit is $100,000, which of the following is the sales
volume needed to achieve the target profit?
(a) 50,000 units
(b) 60,000 units
(c) 70,000 units
(d) 100,000 units


1. 100 units
2. 267 units
3. $10
4. 700 units
5. 771 units

Bibliography
Brealey, Richard A., Franklin Allen, and Steward C. Myers. Principles of

Corporate Finance, McGraw-Hill (2011)
Fridson, Martin S. and Fernando Alvarez. Financial Statement Analysis: A

Practitioner’s Guide, Wiley Finance (2002)
Gibson, Charles K. Financial Reporting & Analysis, South-Western Cengage

Learning (2012)
Horgren, Charles T. and George Foster. Cost Accounting: A Managerial Em-phasis,

Pearson Education (2012)
Hoover’s Company Information (www.hoovers.com)
Kieso, Donald E., Jerry J. Weygandt, and Terry D. Warfield. Intermediate

Accounting, Wiley (2012)
Libby, Robert, Patricia Libby, and Daniel Short. Financial Accounting, McGraw-
Hill (2011)
Subramanyam, K.R. and John L. Wild. Financial Statement Analysis, McGraw-

Hill (2009)
Try, Leo. Almanac of Business and Industrial Financial Ratios, CCH Inc. (2012)
Van Horn, James C. and John M. Wachowicz Jr., Fundamentals of Financial

Management, Prentice Hall (2012)
137
Glossary
Accounting A system that collects and processes (analyzes, measures,

and records) financial information about an organization and reports that in-
formation to decision makers.
Accounts receivable Money owed to the company from customers as a

result from credit sales.
Accounts payable Obligations that arise from the purchase of stock-in-

trade items, supplies, or services on open account.
Accrual accounting The basis for recording transactions under Gener-

ally Accepted Accounting Principles (GAAP). That is, an expense is recorded
when incurred regardless of when the cash payment for the expense is made.
Revenues are recorded when a sale is made, not necessarily when cash flows
occur.
Activity ratios Ratios that measure how efficiently the company man-
ages its assets.
Additional paid-in capital Capital paid into the corporation from the
purchase of capital stock by shareholders for a value in excess of the par value
of the capital stock.
Adjusting entries Certain accounts need adjustment at the end of a pe-

riod so that both the balance sheet and income statement will be accurate at
the end of a period. Adjusting entries fall into five categories: prepaid expenses
requiring apportionment, recorded revenues requiring apportionment, un-
recorded accrued revenues, unrecorded accrued expenses, and valuation of
accounts receivable and investments.
139
Allowance for doubtful accounts A contra-asset account’s balance that

is subtracted from the accounts receivable account balance on the balance
sheet. It is a reserve for bad debts, an estimate of the dollar amount of receiv-
ables that will become uncollectible.
American Accounting Association (AAA) An organization composed

of accounting professors and practicing accountants. The AAA serves as a
critic in appraising accounting practice and recommends improvements
through its quarterly publication, The Accounting Review.
American Institute of Certified Public Accountants (AICPA) The na-

tional professional organization of Certified Public Accountants (CPAs) in
the United States that sets ethical standards for the profession and U.S. audit-
ing standards for audits of private companies, nonprofit organizations, and
federal, state, and local governments.
Accrual accounting Revenue is allocated to the period or periods it is

earned, regardless of when it is collected. Expenses are applied to the period
in which they are incurred rather than the period of their payment or satis-
faction. Accrual accounting is a GAAP method.
Accrued liabilities Expenses, such as wages, interest on note obligations,

property taxes, and rent that accrue (or accumulate) on a daily basis.
Audit A series of procedures carried out by an accountant including per-

forming extensive tests of transactions and internal controls. These procedures
help the accountant be reasonably certain that accounting systems perform
as required by GAAP.
Assets Probable future economic benefits obtained or controlled by a

particular entity as a result of past transactions or events.
Balance sheet Financial statement that identifies a business’s assets, lia-

bilities, and owners’ equity as of a certain date.
Bond A debt investment in which an investor loans money to an entity

(corporate or governmental) for a defined period of time at usually a fixed
interest rate. Bonds are issued by corporations, municipalities, states, and U.S.
and foreign governments to finance a variety of projects.
Break-even point The sales level where revenues are exactly equal to
total costs (fixed plus variable costs).
Capital stock A broad description for the ownership interest in a corpo-

ration. The true ownership interest in a corporation is called common stock,
which is a type of capital stock.

GLOSSARY 141
Cash basis of accounting A type of accounting where revenue is

recorded as earned when received or collected and expense is recorded as in-
curred when paid. The cash basis of accounting is not a GAAP method.
Cash flows from financing activities Cash flows from the issuance of
capital stock, debt securities, dividend payments, repayment of debt, and pur-
chase of treasury stock.
Cash flows from investing activities Cash flows from the purchases and
sales of productive assets and other companies’ debts (bonds and notes) and
equity (common and preferred stocks issued by other companies).
Cash flows from operating activities Cash flows from day-to-day, in-
come-producing activities. They include the activities that are not in the cat-
egories of investing and financing.
Conservatism A underlying assumption of financial statements and a

guiding principle of accounting that requires accountants to choose account-
ing methods that are least likely to overstate assets or inflate income. This
leads to the general rule that unfavorable events are recorded immediately.
The recording of apparently favorable events must wait until the favorable
outcome is assured.
Contribution margin On a per-unit basis the contribution margin is

price minus variable cost per unit. On a company-wide basis it is sales minus
total variable costs.
Cost of goods sold An expense of companies that sell products that is

comprised of those expenses incurred to manufacture or purchase merchan-
dise that has been sold.
Current assets Assets that will most likely be converted into cash, be
sold, or be consumed within a period of one year or within the normal oper-
ating cycle of the business.
Current liabilities Debts and other obligations owed by the company

that will be satisfied within one year.
Debenture An obligation (bond) protected, not by collateral or tangible

assets, but only by the general credit rating of the issuer.
Depletion The allocation (expense) of the cost of a natural resource such

as timber, minerals, and oil as it is extracted from the earth.
Depreciation Allocation (expense) of the cost of a long-term, tangible

asset over the useful life of that asset.

Dividends Income paid to stockholders from the retained earnings of

the business. Dividends are declared (voted) by the board of directors.
Earnings per share A measure of profitability that is important to the

owners of the company (shareholders). In its simple form it is found by di-
viding net income by the number of outstanding shares.
EBIT Earnings before interest and taxes, is caluculated as follows: (I –

Tax Rates) + Depreciation and Amortization – Change in Net Working
Capital – Capital.
Equity Residual interest in the assets of an entity that remains after de-
ducting its liabilities. In a business enterprise, the equity is the ownership in-
terest.
Expenses Outflows or other using-up of assets or incurrence of liabilities

(or a combination of both) during a period resulting from delivering or pro-
ducing goods, rendering services, or carrying out other activities that consti-
tute the entity’s ongoing major or central operations.
FASB 95 The rules that guides the accountant in the preparation of the
statement of cash flows.
Financial Accounting Standards Board (FASB) A nonprofit corporation

that develops the broad conceptual framework for financial accounting and
Generally Accepted Accounting Principles (GAAP).
Financial accounting The type of accounting that serves the needs of

external users such as prospective and current investors, creditors, and regu-
lators. It is guided by General Accepted Accounting Principles (GAAP).
Financial analyst A person who reads and interprets financial statements

so as to make a particular decision. For example, a financial analyst might re-
view financial statements so as to recommend the entity as an investment to
prospective investors or to recommend to a loan officer that the entity be
granted or denied a loan.
Free Cash Flow (FCF) Free cash flow is calculated as follows: Cash Flow
from Operations – Capital Expenditures Required to Maintain Productive
Capacity Used in the Production of Income – Dividends = Free Cash Flow
(FCF)
Fixed costs A cost that does not vary depending on production or sales
levels, such as rent, property tax, insurance, or interest expense.
Full disclosure An accounting principle that requires that the informa-

tion provided in the financial statements and the notes to the financial state-
ments be of sufficient detail to allow the user to make adequate decisions.

GLOSSARY 143
Gains Increases in equity (net assets) from peripheral or incidental trans-

cumstances affecting the entity during a period, except those that result from
revenues or investments by owners.
Generally Accepted Accounting Principles The combination of basic

assumptions and principles that make up a body of knowledge known as Gen-
erally Accepted Accounting Principles (GAAP).
Going-concern assumption The assumption that the entity will con-

tinue in existence into the foreseeable future. This assumption is part of the
reason why asset values are not liquidation values but mostly historical cost
(with a few exceptions where lower of cost or market value or fair market
value is used).
Historical cost The cost used to record the activities and transactions of
a company. Historical cost is a verifiable item and provides an objective basis
for valuation.
Income statement Also called the profit and loss statement or the state-
ment of operations, it is the financial statement that discloses a company’s
profit or loss during a specified period of time. The income statement shows
revenues earned during a period of time, the expenses incurred to produce
that revenue, and the income or loss for that same period.
Institute of Management Accountants (IMA) An association of man-

agement accounting professionals that provides accounting research and ed-
ucation for the internal accountant. In addition, the IMA awards the
Certificate in Management Accounting (CMA).
Internal Revenue Code (IRC) United States law that governs the taxing
of income and the collection of those taxes.
Internal Revenue Service (IRS) A bureau of the Department of the

Treasury responsible for collecting taxes and the interpretation and enforce-
ment of the Internal Revenue Code (IRC).
Inventory Stock of goods available for sale, the merchandise or stock

that a store or company has on hand, or in the case of a manufacturer, raw
materials, work-in-process, and finished goods.
Investments Stocks and bonds owned by the business, land held for fu-
ture use or speculative purposes, and investments set aside in special funds,
such as pension or plant-expansion funds.
Leverage ratios Ratios that help the analyst measure the debt burden of
the company and forecast the solvency of the firm in the long run.

Liabilities Probable future sacrifices of economic benefits arising from

present obligations of a particular entity to transfer assets or provide services
to other entities in the future as a result of past transactions or events.
Liquidity ratios Ratios that attempt to measure a company’s ability to

meet its short-term obligations. There are two popular liquidity ratios: current
ratio and quick (or acid-test) ratio.
Long-term liabilities Liabilities that will not be satisfied within one year
are classified as long term.
Losses Decreases in equity (net assets) resulting from peripheral or in-

cidental transactions of an entity and from all other transactions and other
events and circumstances affecting the entity during a period, except those
that result from expenses or distributions to owners.
Management accounting The type of accounting that serves the infor-

mation needs of staff and management. Its guiding principle is usefulness.
Marketable securities Otherwise called short-term investments, a safe

haven involving the temporary use of excess cash in order to earn interest or
dividends until the cash is needed.
Matching principle Requires a company to match expenses with related

revenues in order to report a company’s net income or loss during a specified
time interval (such as one year).
Materiality A judgment call made by accountants on how some trans-

actions are to be handled. It is similar to the concept of an order of signifi-
cance. The threshold of materiality can allow an accountant to violate another
accounting principle if the amount is so small that the reader of the financial
statements will not be misled. For example, an insignificant asset can be com-
pletely written off as opposed to capitalized if its value is insignificant.
Mixed cost A hybrid cost—part fixed and part variable.
Mortgage payable A long-term loan securing real property. In other

words, real estate is pledged as security for a loan.
Net income The bottom-line figure on the income statement. It is the

difference between revenues and expenses. Net income increases owners’ eq-
uity (whereas net loss decreases owners’ equity).
Net loss The bottom-line figure on the income statement. It is the dif-
ference between revenues and expenses. Net loss decreases owners’ equity
(whereas net income increases owners’ equity).

GLOSSARY 145
Notes payable A written promise signed by the maker of the note to pay
a certain sum of money, either on demand or at a future date. The negotiable
instrument (the note) may or may not bear a rate of interest, although most
notes payable are evidenced by a promissory note that calls for interest.
Operating expenses Costs incurred in carrying out an organization’s day-

to-day activities that include payroll, sales commissions, employee benefits and
pension contributions, transportation and travel, rent, amortization and depre-
ciation, repairs, and various types of taxes. Operating expenses are usually sub-
divided into selling expenses and administrative and general expenses.
Owners’ equity Owners’ investment in a company. For a corporation,

owners’ equity is usually divided into four sub-categories: capital stock at the
par or stated value, additional paid-in capital or amounts paid over par, re-
tained earnings, and treasury stock (negative equity).
Pre-emptive right The right of current shareholders to maintain their

proportional ownership of a company by buying a proportional number of
shares of any future issue of common stock.
Preferred stock A type of capital stock that provides a dividend that is

paid before any dividends are paid to common stockholders and takes prece-
dence over common stock in the event of liquidation.
Prepaid expense An expenditure that is initially recorded as an asset

(current) that will benefit a future period. Examples are: prepaid rent, taxes,
royalties, commission, prepaid office supplies, and insurance.
Profitability ratios Financial ratios that can be used to assess a com-

pany’s ability to control expenses and convert sales into profits.
Profit margin A ratio that shows the percentage of net income produced
by each sales dollar. It is found by dividing net income by sales.
Property, plant, and equipment Also called fixed assets. They are used
in the operation of the business and have a useful life of more than one year.
Public Company Accounting and Oversight Board (PCAOB) A non-

profit corporation created by the Sarbanes–Oxley Act, a 2002 United States
federal law, to oversee and regulate the work of the auditors of the financial
statements of corporations that issue their stock to the public.
Retained earnings Accumulated earnings that are not distributed to the

shareholders. The change in retained earnings equals net income or net loss
less dividends.

Revenues Inflows or other enhancements of assets of an entity or settle-

ment of liabilities (or a combination of both) during a period resulting from
delivering or producing goods, rendering services, or other activities that con-
stitute the entity’s ongoing major or central operations.
Revenue recognition This occurs when the earnings process is complete

and an exchange transaction has occurred.
Sarbanes–Oxley Act of 2002 A United States federal law that set stan-
dards for all U.S. public company boards, management, and public accounting
firms. It was passed in response to a series of large corporate frauds and scan-
dals involving misleading financial reporting. The act established the Public
Company Accounting and Oversight Board (PCAOB).
Securities and Exchange Commission (SEC) Federal regulatory agency

for the securities industry. The SEC is responsible for helping assure that
there is full disclosure of significant financial information and facts and to
protect investors against fraud and manipulative practices in the securities
markets. The SEC enforces the Securities Act of 1933 and the Securities Ex-
change Act of 1934.
Statement of cash flows Provides the user with a detailed summary of

all the cash provided during the period and the uses of the cash.
Statement of retained earnings The financial statement that details the

changes in the retained earning accounts for the same period as the income
statement. The formula for the statement of retained earnings is as follows:
Beginning Retained Earnings + Net Income − Dividends = Ending Retained
Earnings.
Treasury stock The company’s own stock that has been re-acquired by
the company.
Variable costs Costs that vary with some activity level such as production
output or sales volume. For example, variable costs rise as production in-
creases and fall as production decreases.
Unearned revenue Revenues collected before a service is actually per-

formed must be shown as liabilities.
Zero coupon bonds Bonds that are sold at a discount and provide that
all the interest is earned by paying the full face value at maturity.

Online Resources
American Accounting Association (aaahq.org)

American Institute of Public Accountants (www.aicpa.org)
Financial Accounting Standards Board (www.fasb.org)
Institute of Management Accountants (www.imanet.org)
International Financial Reporting Standards Foundation (www.ifrs.org)
Mergent Online (www.mergentonline.com)
Public Company Accounting Oversight Board (pcaobus.org)
Standard and Poor's Industry Surveys Ratios (www.standardandpoors.com)
United States Securities and Exchange Commission (www.sec.gov)
Value Line Investment Survey (valueline.com)
147
Post-Test
How to Read and Interpret Financial Statements
Second Edition
Course Code 98002
INSTRUCTIONS: To take this test and have it graded, please email AMASelfStudy
@amanet.org. You will receive an email back with details on taking your test and get-
ting your grade.
FOR QUESTIONS AND COMMENTS: You can also contact Self Study at 1-800-225-3215
or visit the website at www.amaselfstudy.org.
1. Costs that do not change within a workable range of activity are:

(a) variable.
(b) mixed.
(c) fixed.
(d) direct.
2. Based on the following facts, what is the break-even point?

A company has a fixed cost of $28,000 and a variable cost
per unit of $30. The unit’s selling price is $100.
(a) 300 units
(b) 200 units
(c) 400 units
(d) 500 units
149
3. Based on the following facts, how many units must be sold to earn a
profit of $700? A company has a fixed cost of $28,000 and a variable
cost per unit of $30. The unit’s selling price is $100.
(a) 410 units
(b) 401 units
(c) 400 units
(d) 470 units
4. Which of the following ratios is calculated by dividing current assets by

current liabilities?
(a) Quick
(b) Current
5. Which of the following ratios gives the most conservative indication of

liquidity?
(a) Quick
(b) Current
6. Which of the following categories of ratios answers the question:

How well does the company manage its resources?
(a) Liquidity
(b) Activity
(c) Profitability
(d) Leverage
7. What does the following formula measure?

Cost of Beginning Inventory + Net Purchases − Cost of Ending Inventory
(b) Gross margin
(c) Cost of goods available for sale
(d) Cost of manufactured goods
8. Complete the following formula:

Gross Profit – Operating Expenses = ____________________________.
(a) Net income
(b) Operating income
(c) Gross profit
(d) Contribution margin

POST-TEST 151
9. Which is the lowest level of report issued by a Certified Public

Accountant after developing a working knowledge of the entity and
reading the financial statements to confirm that they are in the correct
form and free from obvious material errors?
(a) Compilation
(b) Review
(c) Standard Audit
(d) Qualified Opinion
10. One metric that management can calculate to see if there was adequate
cash flow during the period to keep productive capacity at current
levels is Free Cash Flow (FCF). FCF is calculated by taking values
from the __________________.
(a) balance sheet
(b) statement of cash flows
(c) retained earnings statement
(d) income statement
11. Which of the following is the organization that is empowered to issue

statements of financial accounting standards and interpretations?
(a) AAA
(b) PCAOB
(c) FASB
(d) IMA
12. Which of the following is not a current asset of a business?

(a) Fixed assets
(c) Inventories
(d) None of the above, since all are current assets
13. Which of the following are assets?

(a) Inventories
(c) Land
(d) All of the above
14. Additional paid-in capital is:

(a) the same as treasury stock.
(b) a type of equity account.
(c) always preferred stock.
(d) a long-term liability.

15. Which of the following is the asset name for amounts due from
customers for sales made or services rendered on account?
(a) Promissory notes
(c) Accruals
(d) Interest receivable
16. Which of the following is not one of the inventory accounts related to
the products that the company sells?
(a) Raw materials
(b) Supplies
(c) Work-in-process
(d) Finished goods
17. Which of the following inventory methods would result in maximizing

(c) Average cost
18. Which of the following inventory methods would result in minimizing

(c) Average cost
19. Which of the following is not a current liability?

(b) Notes payable (due in six months)
(c) Dividends payable
(d) Bond due in ten years
20. Which of the following long-term liabilities creates a lien on company

property?
(a) Bond payable
(b) Mortgage payable
(c) Zero coupon bond
(d) Debenture
21. Which of the following liabilities rarely carries an interest charge?

(b) Notes payable
(c) Bonds payable
(d) Mortgage payable

POST-TEST 153
22. Which of the following income statement formats shows the most
detail?
(a) Single step
(b) Multi-step
(c) Cost-of-goods-sold step
(d) Contribution margin income statement
23. The source of payment of current liabilities usually is derived from

__________________ assets.
(a) long-term
(b) net
(c) current
(d) permanent
24. Under accrual accounting rules, generally, a revenue:

(a) is any cash inflow into a business during the accounting period.
(b) is the result of delivering or producing goods and rendering
services.
(c) can include an increase in equity from transactions that are not
central to the purpose of the firm.
(d) is shown on the statement of cash flows.
25. __________________ income is a company’s change in total

stockholders’ equity from all sources other than the owners of the firm.
(a) Net
(b) Extraordinary
(c) Comprehensive
(d) Interest

Index
AAA, see American Accounting cash basis accounting vs., 77

definition of, 139, 140
depreciation defined by, 49
amortization, 51
Association
accounting, 2–6 for guarantee and warranty annual reports, 3
accrual, 8, 60, 77, 139, 140 costs, 60 Annual Statement Studies (Robert
assumptions made in, 6–7 accrued expenses, 59, 79 Morris Associates), 94
cash basis, 60, 77, 141 accrued liabilities appreciation, 49, 50
definition of, 139 as current liabilities, 59 ASRs (Accounting Series
and external users, 3–5 definition of, 140 Releases), 4
GAAP for, 8–9 accrued revenues, 78–79 assets, 20
and internal users, 2 accumulated depreciation, 49 on balance sheet, 21, 41–54
management, 144 acid-test (quick) ratio, 95–97 categories of, 41
managerial, 2 activity ratios current, 22, 42–46, 141
see also financial accounting definition of, 139 definition of, 21, 41, 140
accounting cycles, 6 types of, 97–103 intangible, 50–52
accounting policies and additional paid-in capital long-term investments as, 24,
practices, in notes to on balance sheet, 26–27 46–48
financial statements, 34 definition of, 139 other, 53
The Accounting Review, 5 as part of owners’ equity, 64 property, plant and equipment
Accounting Series Releases adjusting entries, 139 as, 24, 48–53
(ASRs), 4 AICPA, see American Institute of tangible fixed, 48–50
accounting standards Certified Public wasting, 52–53
FASB’s review and Accountants assumptions, 6–7
establishment of, 4 allowance for doubtful accounts, audit
groups and organizations 43, 140 definition of, 8, 140
influencing, 5 Almanac of Business and Industrial purpose of, 8–9
accounts payable Financial Ratios, 94 audited financial statements, 3, 5
as current liabilities, 25, 58 American Accounting auditor’s opinion, 9, 10
definition of, 139 Association (AAA), 147 auditors’ reports, 9–11
accounts receivable, 43 accounting standards available-for-sale securities, 43
definition of, 139 influenced by, 5 average collection period ratio,
requiring valuation definition of, 140 99, 100
adjustment, 79 American Institute of Certified average cost method, 44–45
Public Accountants
accounts receivable turnover
ratio, 99 (AICPA), 147 Balanced scorecard, 12
accrual accounting, 8 definition of, 140 balance sheet, 22–28
155
assets on, 21, 41–54 cash flows from operating CVP analysis, see cost-volume-
definition of, 140 activities, 84 profit analysis
elements of, 21–22 definition of, 141
equity on, 21 examples of, 85 Debenture (bond), 62, 141
expenses on, 21 Certificate in Management debt
liabilities on, 21, 57–63 Accounting (CMA), 5 installment, 61
limitations of, 12 closing accounts, 21–22 long-term, see long-term
and off-balance-sheet common stock, 26–27 liabilities
financing, 63 competitiveness, measures of, 12 as trading securities, 42
owners’ equity on, 26, 63–66 compilation reports, 9, 11 debt ratio, 104
revenue on, 21 comprehensive income, 75, 76 debt-to-equity ratio, 104–105
balance sheet analysis, 93–108 conservatism, 7, 141 deep discount bonds, 62
ratios in, 94–105 consolidation, 47 depletion, 52, 53, 141
vertical and horizontal, contingent liabilities, 13, 34 depreciation, 49
106–107 contra-asset accounts, 43 accumulated, 49
bank loans, 25 contribution margin, 129–131, definition of, 141
bearer bonds, 62 141 straight-line, 29, 49
bond(s), 25 convertible bonds, 62 diluted EPS (earnings per share),
definition of, 140 copyrights, 51 116
as long-term investment, 46 cost allocation, 29 direct labor, 44, 132
maturity patterns of, 35 cost behavior, 124–125 direct method, 86–87
as trading securities, 42 cost method of valuation, 47 disclosure, 7
types of, 62 cost of goods sold discussion memorandum
bonds payable, 61–63 definition of, 141 (FASB), 4
brand equity, 12 on income statement, 30–31 distributions to owners, 20
break-even analysis, see cost- in income statement analysis, dividends, 142
volume-profit analysis 111–112 dividends payable, 59
break-even point cost of sales, see cost of goods Dun & Bradstreet, 94
calculation of, 125–127 sold
definition of, 140 cost-volume-profit (CVP) Earnings
graphic presentation of, analysis, 125–132 restricted, 65
127–128 advantages of, 131 retained, 27, 65, 145
uses of, 128–129 break-even graph in, 127–128 earnings per share, 116, 142
break-even point calculation EBIT, 89, 142
Capital stock in, 125–127 end-of-period adjustments,
on balance sheet, 26–27 contribution margin in, 77–78
definition of, 140 129–131 equity, 20
in notes to financial limitations of, 132 on balance sheet, 21
statements, 35 using, 128–129 definition of, 21, 142
as part of owners’ equity, 64 coupon bonds, 62 as trading securities, 42
cash, as current asset, 42 CPAs, state societies of, 4 see also owners’ equity
cash basis of accounting cumulative bond interest, 62 equity method of valuation, 47
accrual accounting vs., 77 current asset(s), 22, 42–46 expense recognition, 29
definition of, 141 cash as, 42 expense(s), 21
for guarantee and warranty definition of, 141 in accrual accounting, 8
costs, 60 inventories as, 44–46 accrued, 59, 79
cash dividends payable, 59 marketable securities as, on balance sheet, 21
cash flows from financing 42–43 definition of, 28, 142
activities, 84 prepaid expenses as, 46 on income statement, 73,
definition of, 141 receivables as, 43–44 77–80
examples of, 85 current liabilities, 25, 58–61 operating, 32, 73, 113, 114, 145
cash flows from investing definition of, 141 other, 32
activities, 85 types of, 58–61 prepaid, 46, 78, 145
definition of, 141 current maturities of long-term external users, 3–5
examples of, 85 debt, 58
current ratio, 95, 97

INDEX 157
FactSheets Express, 94 statement of retained earnings

as, 32–33
of balance sheets, 101,
106–107
fair market value, 42
FASB, see Financial supplemental information for, of income statements, 101,
Accounting Standards 34–36 118–119
Board see also individual types of human resources measures, 12
statements
FASB 95, 34
definition of, 142 financing activities IFRS (International Financial
for statement of cash cash flows from, 84, 85, 141 Reporting Standards), 9
flows, 83–86 noncash, 85–86 IMA, see Institute of
FASB interpretations, 4 finished goods account, 44 Management Accountants
FASB standards, 4 first in, first out (FIFO), 45 income
FCF, see free cash flow fixed assets, see property, plant comprehensive, 75, 76
FIFO (first in, first out), 45 and equipment net, 32, 75, 144
financial accounting fixed costs operating, 114
basic principles of, 7 cost behavior of, 124 other, 32
definition of, 3, 142 definition of, 142 income bonds, 62
for external users, 3 franchises, 51 income statement, 28–32, 71–80
Financial Accounting free cash flow (FCF), 89–90 apportionment of revenues
Standards Board calculating, 89 and expenses on, 77–80
(FASB), 3–4, 147 definition of, 142 and cash vs. accrual basis of
definition of, 142 full disclosure, 7, 34, 142 accounting, 77
components of, 73, 75–76
goal of, 3–4
task force of, 4 GAAP, see generally accepted cost of goods sold on, 30–31
financial analyst, 142 accounting principles definition of, 143
financial information GAAP opinion, 11 format for, 71–74
external users of, 3–5 gain(s), 21 information not available
historic, 12 definition of, 143 from, 84
internal users of, 2 on income statement, 75 multi-step, 72, 74
reliability and usefulness unrealized, 42, 75 net income on, 32
of, 1–2 generally accepted accounting operating expenses on, 32
financial ratios, 94–105 principles (GAAP), 8–9 other income (other expenses)
activity, 97–103 and audits, 9–10 on, 32
leverage, 104–105 definition of, 143 sales on, 29
limitations of, 94, 117, 118 statement users’ knowledge of, single-step, 71–73
liquidity, 95–97 3 income statement analysis,
financial statement analysis Generally Accepted Auditing 111–120
aim of, 93 Standards, 10 cost of goods sold in, 111–112
notes in, 36 going-concern assumption, 6, gross profit in, 112–114
purpose of, 10 143 horizontal and vertical, 101,
ratios in, 94–106 goodwill, 51–52 118–119
see also balance sheet goodwill impairment, 51–52 operating expenses in, 113,
analysis; income grading policy, xii 114
statement analysis gross profit, 31, 112–114 operating income in, 114
financial statement(s), 1–3, gross profit margin, 115 profitability ratios in, 115–118
19–37 gross-profit-margin ratio, 112 sales in, 111
assumptions used in gross profit ratio, 112–113 income taxes, 34, 59
creating, 6–8 guarantee costs, 59–60 income taxes payable, 59
balance sheet as, 22–28 guaranteed bonds, 62 indentures, 61
indirect method, 87–88
elements of, 20–22
income statement as, Held-to-maturity securities, 43 Industry Norms and Business Ratios
28–32 historical cost, 7, 12–13 (Dun & Bradstreet), 94
limitations of, 12–13 definition of, 143 inflation, 13
and MD&A, 36 of investments, 47 Institute of Management
notes to, 34–36 of tangible assets, 48–49 Accountants (IMA), 147
statement of cash flows as, horizontal analysis, 106 accounting standards
34, 35 influenced by, 5

definition of, 143 definition of, 21, 144 definition of, 144
intangible assets, 50–52 long-term, 25, 58, 61–63, 144 on income statement, 32
internal controls, 9 licenses, 51 net loss, 75, 144
Internal Revenue Code (IRC), life insurance policies, 46 net realizable value, 44
143 LIFO (last in, first out), 45 net sales, 29, 111
Internal Revenue Service (IRS) limitations of financial noncash financing activities,
accounting standards statements, 12–13 85–86
influenced by, 5 liquidity, 42 noncash investing activities,
definition of, 143 liquidity ratios, 95–97, 144 85–86
internal users, 2 loans, 25, 46 nonmonetary facts, 12
International Financial long-term investments, 24, notes payable
Reporting Standards 46–48 as current liabilities, 58
(IFRS), 9 on balance sheet, 24 definition of, 145
International Financial cost method of valuing, 47 as trading securities, 42
Reporting Standards equity method of valuing, 47 notes receivable, 43
Foundation, 147 long-term liabilities, 25 notes to financial statements, 7,
international standards, 9 current maturities of, 58 34–36
inventory(-ies) definition of, 144 number of days’ inventory ratio,
as current asset, 44–46 types of, 61–63 102
definition of, 143 losses, 21
vertical and horizontal definition of, 144 Off-balance-sheet financing, 63
analysis of, 106 on income statement, 75 online resources, 94, 147
inventory turnover ratio, operating activities, cash flows
100–102 Management accounting, 144 from, 84, 85, 141
investing activities Management Discussion and operating expenses, 73
cash flows from, 85, 141 Analysis (MD&A), 36 definition of, 145
noncash, 85–86 managerial accounting, internal on income statement, 32
investments users of, 2 in income statement analysis,
definition of, 143 manufacturing overhead, 44 113, 114
long-term, 24, 46–48 marketable securities operating income, 114
by owners, 20 as current asset, 42–43 operating leases, 63
requiring valuation definition of, 144 operating profit margin, 115
adjustment, 79 requiring valuation operational results analysis,
short-term, see marketable adjustment, 79 123–134
securities matching concept, 29 contribution margin in,
IRC (Internal Revenue Code), matching principle, 7, 144 129–131
143 material events, in notes to cost behavior in, 124–125
IRS, see Internal Revenue financial statements, 34 cost-volume-profit analysis in,
Service materiality, 7, 144 125–132
MD&A (Management graphic presentation of break-
Joint ventures, 46 Discussion and Analysis), even in, 127–128
36 profit-volume graph in,
Land Mergent Online, 94, 147 132–133
and depreciation, 49 mixed cost(s) using break-even analysis in,
as long-term investment, 46 cost behavior of, 124–125 128–129
last in, first out (LIFO), 45 definition of, 144 other assets, 53
leases/leaseholds monetary units, 6 other income (other expenses),
as intangible assets, 51 mortgages, 25 32
operating, 63 mortgage(s) payable other receivables, 43
leverage ratios, 104–105, 143 definition of, 144 owners, distributions to, 20
liabilities, 20 as long-term liabilities, 61 owners’ equity, 20
accrued, 59, 140 multi-step income statement, 72, on balance sheet, 26, 63–66
on balance sheet, 21, 25, 74 definition of, 145
57–63 parts of, 64–66
contingent, 13, 34 Natural resources, 52–53
current, 25, 58–61, 141 net income, 75

INDEX 159
Par value, 26 registered bonds, 62

restricted earnings, 65
statement of cash flows, 34, 35,
83–90
patents, 51
PCAOB, see Public retained earnings definition of, 146
Company Accounting on balance sheet, 27 format alternatives for, 86–88
and Oversight Board definition of, 145 and free cash flow calculation,
pension plans, 34 as part of owners’ equity, 65 89–90
period costs, 7 retirement programs, 34 nature of, 84–86
periodicity assumption, 6–7 return on assets, 116 usefulness of, 84
Post-Test, xi, 149–150 return on equity, 116 Statement of Financial
pre-emptive right, 145 revenue recognition, 7, 29, 146 Accounting No. 3, 20
preferred stock, 145 revenue(s), 21 statement of financial position,
prepaid expense(s) in accrual accounting, 8 see balance sheet
as current asset, 46 accrued, 78–79 statement of retained earnings,
definition of, 145 on balance sheet, 21 32–33, 146
requiring adjustment, 78 definition of, 28, 146 state societies of CPAs, 4
Pre-Test, xi, xiii–xvii on income statement, 73, stock
product costs, 7 77–80 capital, 26–27, 35, 64, 140
profitability, evaluating, 114 requiring adjustment, 78–79 as long-term investment, 46
profitability ratios unearned, 59, 146 preferred, 145
definition of, 145 review questions, xii as trading securities, 42
in income statement review reports, 9–11 treasury, 27, 65, 146
analysis, 115–118 risks, in notes to financial stock options, 35
profit line, plotting, 132–133 statements, 36 straight-line depreciation, 29, 49
profit margin, 115, 145 Robert Morris Associates, 94 supplemental information, for
financial statements, 34–36
profit-volume graph,
Sales
132–133
property, plant and components of, 111 Tangible fixed assets, 48–50
equipment, 48–53 on income statement, 29 taxes payable, 25, 59
on balance sheet, 24 in income statement analysis, temporary accounts, 21
definition of, 145 111 term bonds, 62
intangible assets as, 50–52 sales allowances, 29 “Think About It...” exercises, xii
in notes to financial sales discounts, 29 Thomson ONE, 94
statements, 35 sales returns, 29 time period assumption, 6–7
tangible fixed assets as, Sarbanes–Oxley Act of 2002, 4, times interest earned ratio, 105
48–50 9, 146 total asset turnover ratio, 102
wasting assets as, 52–53 Securities and Exchange total-debt-to-total-assets ratio,
Public Company Commission (SEC), 147 104
Accounting and definition of, 146 trade accounts pay, see accounts
Oversight Board FASB support from, 4 payable
(PCAOB), 147 role of, 4 trademarks, 51
creation of, 4 separate-entity assumption, 6 trade receivables, 43
definition of, 145 serial bonds, 62 trading securities, 42
purpose of, 4–5 shareholders’ equity, see owner’s treasury stock
purchase price of inventory, equity on balance sheet, 27
44 short-term investments, see definition of, 146
marketable securities as part of owners’ equity, 65
Qualitative variables, 12 single-step income statement,
71–73
trends, on income statements,
113, 114
quarterly reports, 3
specific identification method,
quick (acid-test) ratio, 95–97
44 Uncertainties
Ratios, see financial ratios Standard and Poor’s Industry
Surveys Ratios, 147
with intangibles, 52
in notes to financial
raw materials account, 44
real estate, as long-term standards statements, 35
investment, 46 accounting, 4 unearned revenue
receivables, 43–44, see also auditing, 5 as current liability, 59
specific types of receivables international, 9 definition of, 146

unrealized gain, 42, 75

unrealized losses, 75
unrecorded accrued expenses, 79
unrecorded accrued revenues,
78–79
U.S. GAAP, 9
Value Line Investment Survey,

147
variable costs
cost behavior of, 124
definition of, 146
vertical analysis, 106
of balance sheets, 101,
106–107
of income statements, 101,
118–119
Wages payable, 25
warranty costs, 59–60
wasting assets, 52–53
work in process account, 44
write-offs
of natural resources, 52–53
of receivables, 43–44
Year-end adjustments, 78–79

Zero coupon bonds, 62, 146


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How to Read and Interpret

A Guide to Understanding What the

A Guide to Understanding What the

1 Understanding Financial Statements 1

2 Types of Financial Statements 19

Cost of Goods Sold

3 The Balance Sheet: Assets 41

4 The Balance Sheet: Liabilities and 57

© American Management Association. All rights reserved.

5 The Income Statement 71

6 The Statement of Cash Flows 83

7 Balance Sheet Analysis 93

8 Income Statement Analysis 111

Cost of Goods Sold

9 Analysis of Operational Results 123

FOR QUESTIONS AND COMMENTS:

© American Management Association. All rights reserved.

Pre- and Post-Tests

In your first reading, concentrate on getting an overview of the chapter’s con-

Exercises and Activities

The Review Questions

Questions About Grading/Retaking the Test

© American Management Association. All rights reserved.

1. Costs that do not change within a workable range of activity are:

2. Based on the following facts, what is the break-even point?

4. Which of the following ratios is calculated by dividing current assets by

5. Which of the following ratios gives the most conservative indication of

6. Which of the following categories of ratios answers the question:

7. What does the following formula measure?

8. Complete the following formula:

© American Management Association. All rights reserved.

9. Which is the lowest level of report issued by a Certified Public

11. Which of the following is the organization that is empowered to issue

12. Which of the following is not a current asset of a business?

13. Which of the following are assets?

14. Additional paid-in capital is:

© American Management Association. All rights reserved.

17. Which of the following inventory methods would result in maximizing

18. Which of the following inventory methods would result in minimizing

19. Which of the following is not a current liability?

20. Which of the following long-term liabilities creates a lien on company

21. Which of the following liabilities rarely carries an interest charge?

© American Management Association. All rights reserved.

23. The source of payment of current liabilities usually is derived from

24. Under accrual accounting rules, generally, a revenue:

25. __________________ income is a company’s change in total

© American Management Association. All rights reserved.

ACCOUNTING IS MORE AN ART THAN A

© American Management Association. All rights reserved.

© American Management Association. All rights reserved.

© American Management Association. All rights reserved.

Answers appear at the end of this chapter.

1. Why is accounting more an art than a science? ___________________________________

2. What dictates the standards to be used by management accountants when preparing

3. Why is it necessary that financial information to be used by external users be reported in

“Think About It” continues on next page.

© American Management Association. All rights reserved.

Think About It continued from previous page.

A = Internal User B = External User C = Both

___ Analysis of cost components of a product

___ Annual report to stockholders

___ Lease versus purchase analysis