Chapter 5:

Foundations of Financial
Reporting and The Classified
Balance Sheet
LEARNING OBJECTIVE 1:
CONCEPTS UNDERLYING FINANCIAL
REPORTING
 Objective of Financial Reporting
• Provide information that is
– Useful to those making investment and credit
decisions who have a reasonable understanding of
business and economic activities
– Helpful to present and potential investors, creditors
and other users in assessing the amounts, timing,
and uncertainty of future cash flows
– About economic resources, the claims to those
resources, and the changes in them.
Financial Reporting must enable the user to:

• Asses cash flow prospects = capital providers

and other users need info about the business's
ability to generate cash flows

• Assess management's stewardship = capital

providers and others need info about the
business and other economic events
Goal of generating accounting information:

• To provide data that different users need to

make informed decisions for their unique
situations.
• FASB standards, or qualitative characteristics,
to achieve this goal
 Qualitative Characteristics of Accounting
Information

• Used to judge information

• information provided by financial reporting
often results from approximate rather than
exact measures.
• outcome of economic activity in a dynamic
economy is uncertain and results from
combinations of many factors
 Qualitative Characteristics of Accounting
Information

• Qualitative Characteristics
– The most fundamental of these characteristics are
relevance and faithful representation.
– enhancing characteristics - Comparability,
verifiability, timeliness, and understandability
 Qualitative Characteristics

1.) Relevance
– information has a direct bearing on a decision
– if the information were not available, a different
decision would be made
 Relevance

• to be relevant, information must have

– Predictive value - if it helps capital providers make
decisions about future actions.
– Confirmative Value – (feedback value) if it
confirms, corrects or changes previous evaluations
 Relevance

• Further, it is subject to Materiality

– Information is material if its ommission or
misstatement could influence the user's economic
decisions taken on the basis of the specific entity's
financial statements.
– materiality depends not only on the value of an
item but also on its nature
 Qualitative Characteristics
2.) Faithful Representation
– Means that financial information is
• complete - provides all info necessary for a reliable
decision
• neutral - free from bias
• free from material error - information meets a
minimum level of accuracy so it does not distort what is
being reported
 Enhancing Qualitative Characteristics

• These enhancing characteristics are subject to

the cost constraint (cost benefit) which holds
that the benefits to be gained from providing
accounting information should be greater than
the costs of providing it.
 Enhancing Qualitative Characteristics

3.) Comparability - the quality that enables

users to identify similarities and differences
between two sets of financial data
4.) Verifiability - the quality that different
knowledgeable and independent observers
could reach consensus that a particular
depiction is a faithful representation
 Enhancing Qualitative Characteristics

5.) Timeliness - receive information in time to

influence their decisions

6.) Understandability - enables users to

comprehend the meaning of the information
 Accounting Conventions

• accountants must prepare financial

statements in accordance with accepted
practices.
• Familiarity with accounting conventions or
constraints enables the user to better
understand accounting information
 Accounting Conventions

1.) Consistency - 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.
 Accounting Conventions

2.) Full Disclosure (Transparency) - Financial

statements present all the information
relevant to users understanding of the
statements
- must include any explanation needed to keep
them from being misleading
 Accounting Conventions
• 3.) Conservatism
• -when in doubt, choose the solution that will
least likey to overstate assets and income.
• -most common applications of conservatism is
the use of lower-of-cost-or-market method =
– if an item's market value is greater than its original
cost, the more conservative cost figure is used. If
the market value is below the original cost, the
more conservative market value is used.
LEARNING OBJECTIVE 2:
CLASSIFIED BALANCE SHEET
 Classified Balance Sheet

• Balance sheet present a company’s financial

position at a particular time
• Categorize accounts as assets, liabilities, and
owner’s equity.
• Classified Financial Statements - general-
purpose external financial statements that are
divided into subcategories
 Assets

• Classified balance sheet of a US company

typically divides assets into four categories
(listed in the order of how easily they can be
converted into cash):
– current assets
– Investments
– property,plant and equipment
– Intangible assets
 Assets

• 1.) Current assets - 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
 Assets

• 2.) Investments - include assets that are not

used in normal business operations and that
management does not plan to convert to cash
within the next year
• ex. securities held for long term investment,
long term notes receivable, land held for
future use, plant or equipment not used in the
business,
 Assets

• 3.) Property, Plant and Equipment - also

called operating assets, fixed assets, tangible
assets, long-lived assets, or plant assets.
• include tangible long term assets used in a
business' day-to-day operations.
 Assets

• 4.) Intangible assets - long term assets with no

physical substance. Their value stems from the
rights or privileges accruing to their owners.
• ex. patents, copyrights, franchises and
trademarks
 Liabilities
• two categories:
– current liabilities
– long term liabilities
 Liabilities

• 1.) Current Liabilities - obligations that must

be satisfied within one year or within the
company's normal operating cycle.
• ex. notes payable, accounts payable, the
current portion of long term debt, salaries and
wages payable, customer advances (unearned
revenues)
 Liabilities

• 2.) Long term liabilities - are debts that fall

due more than one year in the future or
beyond the normal operating cycle and thus
will be paid out of noncurrent assets.
• ex. mortages payable, long-term notes, bonds
payable, employee pension obligations, long
term lease liabilities
 Owner's equity

• Owner's equity, proprietorship, owner's

capital and net worth
• are used to refer to the owner's interest, or
equity in a company.
• equity section of the balance sheet differs
depending on whether the business is a sole
proprietorship, partnership or a corporation
 Owner's equity

• 1.) Sole proprietorship - owner's equity section

would be similar to the one shown in exhibit 3

• 2.) Partnership - called partner's equity. much

like in a sole proprietorship balance sheet.

• 3.) Corporation - by law, separate, legal entities

that are owned by their stockholders.
 Owner's equity >> Corporation

• called stockholder's entity (or shareholders

entity) and has two parts
• --contributed capital
• --retained earnings
• Contributed Capital (or Paid-in Capital) - reflect
the amounts of assets invested by stockholders
 Owner’s Equity >> Corporation

• Retained Earnings- (Earned Capital)

represents the stockholders’ claim to the
assets that are earned from operations and
reinvested in corporate operations.
– Dividends - Distributions of assets to shareholders
• Reduce retained earnings just as withdrawals of assets
by the owner of a business reduce the capital account.