Chapter 3: How is the Statement of Earnings Prepared and Analyzed Flashcards
What is the process for preparing a classified statement of earnings?
The process for preparing a classified statement of earnings involves several steps, including:
Ensuring that the debits equal credits by generating a trial balance.
Listing accounts in a specific order: assets, liabilities, shareholders’ equity accounts, followed by revenues/gains, and expenses/losses.
Taking ending account balances from the trial balance.
Identifying new revenue, gain, and expense accounts.
Noting that the trial balance is labeled “unadjusted” until end-of-period adjustments are made to reflect all revenues earned and expenses incurred.
Why are adjustments necessary for the statement of earnings, and what are some examples of items that need adjustment?
Adjustments are necessary for the statement of earnings because it may not reflect all revenues earned or expenses incurred in a specific period accurately.
Some examples of items that need adjustment include:
Prepaid expenses (e.g., rent and insurance) that cover multiple months but haven’t had expenses recorded for the amounts used in the current period.
Equipment usage during the period that hasn’t been accounted for.
Income tax expenses incurred in the period but not yet calculated and recorded.
Deferred revenue (liability) not updated for additional revenue earned during the period.
These adjustments ensure that assets, expenses, liabilities, and revenues are accurately represented in the statement of earnings.
What is the Total Asset Turnover Ratio, and how is it calculated?
The Total Asset Turnover Ratio assesses how efficiently a company’s management generates sales from its assets. It is calculated as follows:
Total Asset Turnover Ratio = Sales (or operating revenues) / Average total assets
Interpretation: A higher asset turnover ratio indicates more efficient use of assets to generate revenue.
Creditors and financial analysts use this ratio to evaluate a company’s control over current and non-current assets.
Seasonal fluctuations and changes in corporate policies can impact this ratio, so a detailed analysis of revenue and asset components is necessary for a comprehensive understanding of management decisions and investment considerations.
What is Return on Assets (ROA), and how is it calculated?
Return on Assets (ROA) measures how efficiently a company uses its total investment in assets financed by both debtholders and shareholders during a period. It is calculated as follows:
ROA = Net earnings / Average total assets
Interpretation: ROA is a comprehensive measure of profitability and management effectiveness, independent of financing strategy.
It indicates how much a company earns for each dollar of investment in assets.
Higher ROA signifies better investment performance, all other factors being equal. It can be used to evaluate performance at various organizational levels, such as divisions or product lines.
Explain the key difference between net earnings and cash flow from operating activities and why this difference exists.
Net earnings are based on accrual accounting, recognizing revenue when earned and expenses when incurred.
Cash flow from operating activities is based on actual cash receipts and payments.
The difference arises because accrual accounting doesn’t consider the timing of cash movements.
Why is it essential for companies to generate positive cash flows from operating activities, and what are the consequences of negative cash flows in this category?
Positive cash flows from operating activities are necessary to meet obligations like paying suppliers and employees.
Negative cash flows may force a company to sell assets, borrow at high interest rates, or issue additional shares, all of which have negative implications for the business.
How does accrual basis accounting impact the relationship between net earnings and cash flow from operating activities?
Accrual basis accounting recognizes revenues and expenses based on when they are earned or incurred, not when cash is received or paid.
This results in differences between net earnings and cash flow from operating activities.
