Chapter 2

 The Classified Balance Sheet – a balance sheet that contains a number of

standard classifications or sections.
Assets Liabilities and Stockholder’s Equity
Current assets Current liabilities
Long-term investments Long-term liabilities
Property, plant, and equipment Stockholder’s equity
Intangible assets
 Current Assets – assets that a company expects to convert to cash or use up
within one year.
o Common current assets are cash, short-term investments, receivables
(notes receivable, accounts receivable, and interest receivable),
inventories, and paid expenses (insurance and supplies).
 Operating Cycle – the average time it takes a company to purchase inventory,
sell it on account, and then collect cash from customers.
o For most is takes less than 1 year.
o Except when noted assume that a company use one year to determine
whether an asset or liability is current or long-term.
 Long-Term Investments – generally investments in stocks and bonds of other
corporations that are normally held for many years.
o Investment is someone else’s stock
 Property, Plant, and Equip. – Assets with relatively long useful lives that a
company is currently using in operating the business.
o Land, buildings, machinery, equipment, furniture
o Depreciation – the practice of allocating the cost of assets to a number
of years.
o Accumulated depreciation – the total amount of depreciation that the
company has expensed thus far in the asset’s life. Contra assets – goes
with the assets but works against them.
 Intangible Assets –assets that do not have physical substance
o Patents, copy-rights, trademarks
 Current Liabilities –obligations that the company is to pay within the coming
year.
o Accounts payable, wages payable, bank loans payable, interest
payable, and taxes payable
o List notes payable 1st followed by accounts payable and then other
liabilities in order of magnitude
 Long-Term Liabilities – obligations that a company expects to pay after one
year.
o Bonds payable, mortgages payable, long-term notes payable, lease
liabilities, and pension liabilities
 Stockholder’s Equity - 2 parts
o Common stock – the investments of assets into the business by the
stockholder
 o Retained earnings – the income retained for use in the business

Using the Financial Statements

 Ratio Analysis - expresses the relationship among selected items of financial
statement data
o Ratio – expressed the mathematical relationship between one
quantity and another.
o Expressed in either a percentage, a rate, or a simple proportion
o Divide current assets by current liabilities
o Profitability ratios – measure the income or operating success of a
company for a given period of time
o Liquidity ratios – measure short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for cash. Short-
term creditors.
o Solvency ratios – measure the ability of the company to survive over a
long period of time. Long term creditors.
 Profitability Ratio – measures the operating success of a company for a given
period of time.
 Earnings Per Share (EPS) - measures the net income earned on each share of
common stock.
o Divide net income by the average number of common shares
outstanding during the year.
 Statement of Stockholder’s Equity –a financial statement that presents the
factors that caused stockholder’s equity to change during the period of time,
including those that caused retained earnings to change.
 Liquidity - the ability to pay obligations expected to become due within the
next year or operating cycle.
 Working Capital – the difference between the amounts of current assets and
current liabilities.
o Working capital = current assets – current liabilities
o When working capital is positive, current assets exceed current
liabilities.
 Greater likelihood that the company will pay its liabilities.
o When working capital is negative a company may not be able to pay
short-term creditors, and may be forced into bankruptcy.
 Liability Ratio – measures the short-term ability of the enterprise to pay its
maturing obligations and to meet unexpected needs for cash.
 Current Ratio –a measure used to evaluate a company’s liquidity and short-
term debt-paying ability
o Current ratio = current assets / current liabilities
o More dependable indicator of liquidity than working capital
Accounting Across the Organization
  Solvency – a company’s ability to pay interest as it comes due and to repay
the balance of a debt due at its maturity.
 Solvency Ratios – measure the ability of the enterprise to survive over a long
period of time.
 Debt to Total Assets Ratio – measures the percentage of total financing
provided by creditors
o Total debt / total assets
 Free Cash Flow – cash provided by operating activities adjusted for capital
expenditures and dividends paid.
o Free cash flow = cash provided by operations – capital expenditures – cash dividends
The Standard-Setting Environment
 Generally Accepted Accounting Principles – a set of rules and practices,
having substantial authoritative support that the accounting profession
recognizes as a general guide for financial purposes.
 Security and Exchange Commission (SEC) – the agency of the US govt that
oversees US financial markets and accounting standard-setting bodies.
 Financial Accounting Standards Board (FASB) – the primary accounting
standard-setting body in the US
 International Accounting Standards Board (IASB) - an accounting standard-
setting body that issues standards adopted by many countries outside of the
US.
 Characteristics of Useful Info
o Relevance – the quality of info that indicates the info makes a
difference in a decision
o Reliability –information that can be depended on
 Prove that information is free of error
o Comparability – ability to compare the accounting info of different
companies because they use the same accounting principles.
o Consistency – a company uses the same accounting principles and
methods from year to year.
 Assumptions and Principles in Financial Reporting
o Monetary Unit Assumption - an assumption that requires that only
those things that can be expressed in money are included in the
accounting records.
o Economic Entity Assumption –every economic entity can be
separately identified and accounted for.
o Time Period Assumption –the life of a business can be divided into
artificial time periods and that useful reports covering those periods
can be prepared for the business.
o Going Concern Assumption – states that the business will remain in
operation for the foreseeable future.
o Cost Principle – dictates that assets be recorded at their cost.
o Full Disclosure Principle – requires that companies disclose all
circumstances and events that would make a difference to financial
statement users.
 Constraints in Accounting
o Materiality – a financial statement item’s impact on a company’s
overall financial condition and operations.
o Conservatism - when preparing financial statements, a company
should choose the accounting method that will be least likely to
overstate assets or income