Chapter 2: Financial statements and the annual report Flashcards
How would you evaluate the following statement: The cash flows to a company are irrelevant to an investor; all the investor cares about is the potential for receiving dividends on the investment.
The primary concern to an investor is the future cash to be received from the investment. However, this does not mean that the cash flows of the company that has been invested in are not relevant. A relationship exists between the cash flows to the investor and those to the company. For example, a company that does not consistently generate sufficient cash flows from its operations will not be able to pay cash dividends to the investors over a sustained time.
What does relevance mean with regard to the use of accounting information?
Relevance is the capacity of accounting information to make a difference in a financial decision. For example, an income statement is relevant when the use of it has at least the potential to make a difference in an investment decision.
What is the difference between comparability and consistency as they relate to the use of accounting information?
Comparability is the quality of information that allows for comparisons to be made between two or more companies, whereas consistency is the quality that allows for comparisons to be made within a single entity from one accounting period to the next.
How does the concept of materiality relate to the size of a company?
The concept of materiality is closely related to the size of a company. For example, assume that a company must decide whether a $500 expenditure that will benefit future periods should be expensed immediately or capitalized (i.e., recorded as an asset). The decision cannot be made without considering the amount in relation to the size of the company. An amount that is immaterial for a large multinational corporation may be material for a smaller business.
State the overriding objective of financial reporting. Are financial statements intended to report the value of the reporting entity? Explain your answer.
The overriding objective of financial reporting is to provide financial information to permit users of the information to make informed decisions. Financial statements do not report the value of the reporting entity, but should provide useful information to allow users to make estimates of the value of the entity.
What two fundamental characteristics make accounting information useful? What other qualities enhance the usefulness of financial information?
The two fundamental qualities that make accounting information useful are relevance and faithful representation. Financial information is enhanced when it is understandable, comparable, and consistent.
How does the concept of the operating cycle relate to the definition of a current asset?
A current asset is an asset that a company expects to realize in cash, sell, or consume during its normal operating cycle. Therefore, accounts receivable, inventory, and supplies all meet this definition and are classified as current assets. By their nature, the benefits from each of these assets will be realized during the normal operating cycle of the business.
How would you evaluate the following statement: A note payable with an original maturity of five years will be classified on the balance sheet as a long-term liability until it matures.
The note payable will be classified on the balance sheet as long term until one year from its maturity date. At that time, it should be reclassified from long term to current because it will be paid within the next year. Any liability that will mature within one year of the date of the balance sheet should be classified as current, regardless of the original term of the loan (five years in this case).
How do the two basic forms of owners’ equity for a corporation—capital stock and retained earnings—differ?
Capital stock and retained earnings represent claims of the stockholders on the assets of the business, but differ in the source of those claims. Capital stock represents the claims of the stockholders that arise from their contributions of cash and other assets to the business. Retained earnings represent the accumulated earnings, or net income, of the business since its inception less all dividends declared during that time.
What are the limitations of working capital as a measure of the liquidity of a business as opposed to the current ratio?
Using working capital as a measure of liquidity does not allow someone to compare the relative liquidity of two companies of different sizes. Even within a single company, it may be difficult to compare the relative liquidity of the company over time if the company has grown. The current ratio (current assets divided by current liabilities) overcomes these deficiencies by focusing attention on the relative size of the current assets and current liabilities.
What is the major weakness of the single-step form for the income statement?
The single-step form does not highlight the relationships between key items on the statement. For example, the relationship between sales revenue and the cost of the products sold is very important for a product-oriented company. The difference between the two amounts is called gross profit and would appear on a multiple-step statement but not on the single-step form.
How does a statement of retained earnings act as a link between an income statement and a balance sheet?
A statement of retained earnings shows the beginning balance in the account, the addition (deduction) to the account for the net income (loss) of the period, and any deduction from the account for dividends. The beginning balance in Retained Earnings is taken from the balance sheet at the end of the prior period. The income statement indicates the net income for the period. The ending balance in Retained Earnings appears on the balance sheet at the end of the period.
A company borrowed $100,000 from its bank and the next day used $80,000 of the cash from the loan to buy a new piece of equipment for its plant. Explain how each of those activities is reported on a statement of cash flows.
A company borrowed $100,000 from its bank and the next day used $80,000 of the cash from the loan to buy a new piece of equipment for its plant. Explain how each of those activities is reported on a statement of cash flows.
In auditing the financial statements of a company, does the auditor certify that the statements are totally accurate without errors of any size or variety? Explain
An audit of a set of financial statements does not ensure that the statements contain no errors. Because of the sheer number of transactions entered into during a period of time, it would be impossible for an auditor to check every single transaction to determine that it was correctly recorded. Instead, through various types of tests, the auditor renders an opinion as to whether the statements are free of material misstatement.
What is the second note that accompanies Panera Bread’s financial statements in its Form 10-K? What is its purpose?
The second note is the summary of significant accounting policies. The purpose of this note is to summarize all of the company’s important accounting policies, such as those relating to the method of depreciating assets and the policy for recognizing revenue.
