Principles of financial accounting 12e by needles crosson chapter 05

CHAPTER

5

Foundations of Financial
Reporting and the
Classified Balance Sheet

Principles of
Accounting
12e
Needles
Powers
Crosson
© human/iStockphoto


LEARNING OBJECTIVES
 LO1: Describe the objective of financial
reporting, and identify the conceptual
framework underlying accounting information.
 LO2: Identify and define the basic
components of financial reporting, and
prepare a classified balance sheet
 LO3: Use classified financial statements to
evaluate liquidity and profitability.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


SECTION 1: CONCEPTS

(slide 1 of 3)

 Re le vanc e : information has a direct bearing on a decision
– Pre dic tive value : information helps capital providers make
decisions about future actions
– Co nfirmative value : information confirms or changes previous
evaluations
– Mate riality: the omission or misstatement of information could
influence the user’s economic decisions taken on the basis of the
financial statements

 Faithful re pre s e ntatio n: information is complete, neutral, and
free from material error
– Co mple te ne s s : all information necessary for a reliable decision is
provided
– Ne utrality: information is free from bias intended to achieve a
certain result or bring about a particular behavior
– Fre e fro m mate rial e rro r: information meets a minimum level of
accuracy so it does not distort what is being reported
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


SECTION 1: CONCEPTS
(slide 2 of 3)

 Enhanc ing qualitative c harac te ris tic s
– Co mparability: the quality that enables users to identify
similarities and differences between two sets of financial
data
– Ve rifiability: the quality that different knowledgeable and

independent observers could reach consensus, although
not necessarily complete agreement, that a particular
depiction is a faithful representation
– Time line s s : the quality that enables users to receive
information in time to influence their decisions
– Unde rs tandability: the quality that enables users to
comprehend the meaning of information
– Co s t c o ns traint (c o s t-be ne fit): the benefits to be gained
from providing accounting information should be greater
than the costs of providing it
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


SECTION 1: CONCEPTS
(slide 3 of 3)

 Ac c o unting c o nve ntio ns : constraints used in
preparing financial statements
– Co ns is te nc y: once a company has adopted an accounting
procedure, it must use it from one period to the next unless
a note to the financial statements informs users of a change
– Full dis c lo s ure (trans pare ncy): financial statements must
present all the information relevant to users’ understanding
of the statements
– Co ns e rvatis m: when faced with choosing between two
equally acceptable procedures or estimates, accountants
should choose the one that is least likely to overstate
assets and income

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Objective of Financial Reporting
 To be useful for decision making, financial reporting
must enable the user to
– Assess cash flow prospects
– Assess management’s stewardship
 Financial reporting includes the financial statements
(balance sheet, income statement, statement of
owner’s equity, and statement of cash flows) that are
prepared periodically.
– Management’s underlying assumptions and
methods and estimates used in the financial
statements are also important components of
financial reporting.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Qualitative Characteristics of
Accounting Information
 To facilitate interpretation of accounting
information, the FASB has established
standards, or qualitative c harac te ris tic s , by
which to judge the information.
 The most fundamental of these
characteristics are:
– Relevance
– Faithful representation

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Relevance
(slide 1 of 2)

 Re le vanc e means that the information has a
direct bearing on a decision. In other words, if
the information were not available, a different
decision would be made.
– To be relevant, information must have one or both
of the following:
 Predictive value—Information has pre dic tive value if it
helps capital providers make decisions about future
actions.
 Confirmative value—Information has c o nfirmative value
if it confirms or changes previous evaluations.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Relevance
(slide 2 of 2)

 Relevant information is also subject to m ate riality.
– Information is mate rial if its omission or
misstatement could influence the user’s economic
decisions taken on the basis of the specific entity’s
financial statements.
– Mate riality is related to both the nature of an item and its
size or misstatement.

 The materiality of an item normally is determined by
relating its dollar value to an element of the financial
statements, such as net income or total assets.
 As a rule, when an item is worth 5 percent or more of net
income, accountants treat it as material.
 However, many small errors can add up to a material
amount.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Faithful Representation
 Faithful re pre s e ntatio n means that the
financial information is complete, neutral, and
free from material errors.
– Co mple te info rmatio n provides all information
necessary for a reliable decision.
– Ne utral info rmatio n is free from bias intended to
achieve a certain result or to bring about a
particular behavior.
– To be fre e fro m mate rial e rro r means
information meets a minimum level of accuracy so
it does not distort what is being reported.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Enhancing Qualitative Characteristics
(slide 1 of 2)

 Other characteristics that the FASB has established
for interpreting accounting information include:

– Co mparability—enables users to identify
similarities and differences between two sets of
financial data.
– Ve rifiability—different knowledgeable and
independent observers could reach consensus
that a particular depiction is a faithful
representation.
– Time line s s —enables users to receive information
in time to influence their decisions.
– Unde rs tandability—enables users to
comprehend the meaning of the information.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Enhancing Qualitative Characteristics
(slide 2 of 2)

 These enhancing characteristics are subject
to the c o s t c o ns traint (or c o s t-be ne fit),
which holds that the benefits to be gained
from providing accounting information should
be greater than the costs of providing it.
– Minimum levels of relevance and faithful
representation must be reached if accounting
information is to be useful.
– Beyond the minimum levels, it is up to the FASB,
the SEC, and the accountant who provides the
information to judge the costs and benefits in
each case.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounting Conventions
(slide 1 of 2)

 Ac c o unting c o nve ntio ns , or cons traints , used in
preparing financial statements include:
– Co ns is te nc y—requires that once a company has
adopted an accounting procedure, it must use it
from one period to the next unless a note to the
financial statements informs users of a change.
– Full dis c lo s ure (or trans pare ncy)—requires that
financial statements present all the information
relevant to users’ understanding of the
statements, including:
 any explanation needed to keep them from being
misleading.
 the disclosure of significant events arising after the
balance sheet date.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Accounting Conventions
(slide 2 of 2)

– Co ns e rvatis m—holds that, when faced
with choosing between two equally
acceptable procedures or estimates, the
accountant should choose the one that is
least likely to overstate assets and income.

 Conservatism can be a useful tool, but if
abused, can lead to incorrect or misleading
financial statements.
 Accountants should apply the conservatism
convention only when they are uncertain about
which accounting procedure or estimate to
use.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Ethical Financial Reporting
 Under the Sarbanes-Oxley Act, chief
executive officers and chief financial officers
of all publicly traded companies must certify
that, to their knowledge, their quarterly and
annual statements are accurate and
complete.
 Fraudulent financial reporting can have high
costs for investors, lenders, employees, and
customers—as well as for the people who
condone, authorize, or prepare misleading
reports.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Classified Balance Sheet
 General-purpose external financial statements that
are divided into subcategories are called c las s ifie d
financ ial s tate me nts .
 The subcategories into which assets, liabilities, and

owner’s equity are broken down are shown below.

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Assets
 The classified balance sheet typically divides
assets into four categories: current assets;
investments; property, plant, and equipment;
and intangible assets.
 These categories are listed in the order of
how easily they can be converted to cash.
 Some companies group investments,
intangible assets, and other miscellaneous
assets into a category called o the r as s e ts .

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Current Assets
 Curre nt as s e ts include cash and other assets that a
company can reasonably expect to convert to cash,
sell, or consume within one year or its normal
operating cycle, whichever is longer.
– A company’s no rmal o pe rating c yc le is the average time it
needs to go from spending to receiving cash.
– Current assets include: cash; short-term investments; notes
and accounts receivable; inventory that a company expects
to convert to cash (by selling it) within the next year or the
normal operating cycle; prepaid expenses; and supplies

bought for use.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Investments


Inve s tme nts include assets, usually long-term,
that are not used in normal business operations
and that management does not plan to convert to
cash within the next year. Examples include:
– Securities held for longterm investment
– Long-term notes
receivable
– Land held for future use
– Plant or equipment not
used in business

– Special funds established
to pay off a debt or buy a
building
– Large permanent
investments made in
another company for the
purpose of controlling that
company

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Property, Plant, and Equipment
 Pro pe rty, plant, and e quipme nt include tangible
long-term assets used in a business’s day-to-day
operations.
– They are also called ope rating as s e ts , fixe d as s e ts , tangible
as s e ts , long-live d as s e ts , or plant as s e ts .
– Through depreciation, the costs of these assets (except
land) are spread over the periods they benefit.
– To reduce clutter on the balance sheet, property, plant, and
equipment and related accumulated depreciation accounts
are often combined—for example:
Property, plant, and equipment (net)

$116,240

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Intangible Assets
 Intang ible as s e ts are long-term assets with
no physical substance. Their value stems
from the rights or privileges accruing to their
owners. Examples include:
–
–
–
–
–

Patents
Copyrights
Franchises
Trademarks
Go o dwill—arises in an acquisition of another
company

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Liabilities


Liabilities are divided into two categories:
- Curre nt liabilitie s —
obligations that must be
satisfied within one year or
within the company’s
normal operating cycle,
whichever is longer.
 Notes payable
 Accounts payable
 Current portion of longterm debt
 Salaries and wages
payable
 Customer advances

- Lo ng -te rm liabilitie s —
debts that fall due more
than one year in the

future or beyond the
normal operating cycle.
 Mortgages payable
 Long-term notes
 Bonds payable
 Employee pension
obligations
 Long-term lease
liabilities

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Owner’s Equity
 The terms owne r’s e quity, proprie tors hip,
owne r’s capital, and ne t worth are all used to
refer to the owner’s interest, or equity, in a
company.
– The first three terms are preferred to ne t worth
because many assets are recorded at their
original cost rather than at their current value.

 The equity section of the balance sheet
differs depending on whether the business is
a sole proprietorship, partnership, or
corporation.
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Sole Proprietorship

 The owner’s equity section of a sole
proprietorship would be similar to the one
shown for Bonali Company:

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Partnership
 The equity section of a partnership’s balance
sheet is called partne rs ’ e quity.
 It is much like that in a sole proprietorship’s
balance sheet and might appear as follows:

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.