Финансовый учет. Ридер

before you go on...

RATIO ANALYSIS

Do it! The following information is available for Ozone Inc.

(a)Compute earnings per share for 2012 and 2011 for Ozone, and comment on the change. Ozone’s primary competitor, Frost Corporation, had earnings per share of $2 in 2012. Comment on the difference in the ratios of the two companies.

(b)Compute the current ratio and debt to total assets ratio for each year, and comment on the changes.

(c) Compute free cash flow for each year, and comment on the changes.

Solution

Ozone’s profitability, as measured by the amount of income available to each share of common stock, increased by 25% [($1.00 $0.80) $0.80] during 2012. Earnings per share should not be compared across companies because the number of shares issued by companies varies widely. Thus, we cannot conclude that Frost Corporation is more profitable than Ozone based on its higher EPS.

The company’s liquidity, as measured by the current ratio, improved from 1:60:1 to 2.20:1. Its solvency also improved, as measured by the debt to total assets ratio, which declined from 44% to 30%.

(c) Free cash flow

2012: $110,000 $45,000 ($10,000 $5,000) $50,000 2011: $70,000 $20,000 ($10,000 $2,500) $37,500

The amount of cash generated by the company above its needs for dividends and capital expenditures increased from $37,500 to $50,000.

Related exercise material: BE2-3, BE2-5, BE2-6, Do it! 2-3, E2-7, E2-9, E2-10, and E2-11.

Action Plan

•Use the formula for earnings per share (EPS): (Net income Preferred stock dividends) (Average common shares outstanding).

•Use the formula for the current ratio: Current assets Current liabilities.

•Use the formula for the debt to total assets ratio: Total liabilities Total assets.

•Use the formula for free cash flow: Cash provided by operating activities Capital expenditures Cash dividends.

Financial Reporting Concepts

In Chapter 1, you learned about the four financial statements, and in this chapter, we introduced you to some basic ways to interpret those statements. In this last section, we will discuss concepts that underly these financial statements. It would be unwise to make business decisions based on financial statements without understanding the implications of these concepts.

THE STANDARD-SETTING ENVIRONMENT

How does Best Buy decide on the type of financial information to disclose? What format should it use? How should it measure assets, liabilities, revenues, and expenses? Best Buy and all other U.S. companies get guidance from a set of rules and practices that have authoritative support, referred to as generally accepted accounting principles (GAAP). Standard-setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards.

study objective 6

Explain the meaning of generally accepted accounting principles.

International Note Over 100 countries use international standards (called IFRS). For example, all companies in the European Union follow international standards. The differences between U.S. and international standards are not generally significant. In this book, we highlight any major differences using International Notes like

this one, as well as a more indepth discussion in the A Look at IFRS section at the end of each chapter.

The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. financial markets and accounting standardsetting bodies. The Financial Accounting Standards Board (FASB) is the primary accounting standard-setting body in the United States. The International Accounting Standards Board (IASB) issues standards called International Financial Reporting Standards (IFRS), which have been adopted by many countries outside of the United States. Today, the FASB and IASB are working closely together to minimize the differences in their standards. Recently, the SEC announced that foreign companies that wish to have their shares traded on U.S stock exchanges no longer have to prepare reports that conform with GAAP, as long as their reports conform with IFRS. The SEC is currently evaluating whether the United States should eventually adopt IFRS as the required set of standards for U.S. publicly traded companies. Another relatively recent change to the financial reporting environment was that, as a result of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) was created. Its job is to determine auditing standards and review the performance of auditing firms. If the United States adopts IFRS for its accounting standards, it will also have to coordinate its auditing regulations with those of other countries.

study objective 7

Discuss financial reporting concepts.

International Insight

The Korean Discount

If you think that accounting standards don’t matter, consider recent events in South Korea. For many years, international investors complained that the financial reports of South Korean companies were inadequate and inaccurate. Accounting practices there often resulted in huge differences between stated revenues and actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of comparable companies in different countries. This difference in share price was often referred to as the “Korean discount.”

In response, Korean regulators decided that, beginning in 2011, companies will have to comply with international accounting standards. This change was motivated by a desire to “make the country’s businesses more transparent” in order to build investor confidence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international standards or to create standards that are based on the international standards.

Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).

?What is meant by the phrase “make the country’s businesses more transparent”? Why would increasing transparency spur economic growth? (See page 96.)

QUALITIES OF USEFUL INFORMATION

Recently, the FASB and IASB completed the first phase of a joint project in which they developed a conceptual framework to serve as the basis for future accounting standards. The framework begins by stating that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 2-17.

Faithful Representation Faithful representation means that information accurately depicts what really happened. To provide a faithful representation, information must be complete (nothing important has been omitted) and neutral (is not biased toward one position or another).

Illustration 2-17

Fundamental qualities of useful information

Illustration 2-18 Key assumptions in financial reporting

Ethics Note The importance of the economic entity assumption is illustrated by scandals involving Adelphia. In this case, senior company employees entered into transactions that blurred the line between the employees’ financial interests and those of the company. For example, Adelphia guaranteed over $2 billion of loans to the founding family.

Materiality Constraint The materiality constraint relates to a financial statement item’s impact on a company’s overall financial condition and operations. An item is material when its size makes it likely to influence the decision of an investor or creditor. It is immaterial if it is too small to impact a decision maker. If the item does not make a difference, the company does not have to follow GAAP in reporting it.

Illustration 2-19

Constraints in financial reporting

study objective 1

Identify and discuss the major characteristics of a corporation.

The Corporate Form of Organization

A corporation is created by law. As a legal entity, a corporation has most of the rights and privileges of a person. The major exceptions relate to privileges that can be exercised only by a living person, such as the right to vote or to hold public office. Similarly, a corporation is subject to the same duties and responsibilities as a person. For example, it must abide by the law and it must pay taxes.

We can classify corporations in a variety of ways. Two common classifications are by purpose and by ownership. A corporation may be organized for the purpose of making a profit (such as Nike or General Motors), or it may be a nonprofit charitable, medical, or educational corporation (such as the Salvation Army or the American Cancer Society).

Classification by ownership differentiates publicly held and privately held corporations. A publicly held corporation may have thousands of stockholders, and its stock is traded on a national securities market such as the New York Stock Exchange. Examples are IBM, Caterpillar, and General Electric. In contrast, a privately held corporation, often referred to as a closely held corporation, usually has only a few stockholders and does not offer its stock for sale to the general public. Privately held companies are generally much smaller than publicly held companies, although some notable exceptions exist. Cargill Inc., a private corporation that trades in grain and other commodities, is one of the largest companies in the United States. This chapter deals primarily with issues related to publicly held companies.

CHARACTERISTICS OF A CORPORATION

In 1964, when Nike’s founders, Knight and Bowerman, were just getting started in the running shoe business, they formed their original organization as a partnership. In 1968, they reorganized the company as a corporation. A number of

characteristics distinguish a corporation from sole proprietorships and partnerships. The most important of these characteristics are explained below.

Separate Legal Existence

As an entity separate and distinct from its owners, the corporation acts under its own name rather than in the name of its stockholders. Nike, for example, may buy, own, and sell property, borrow money, and enter into legally binding contracts in its own name. It may also sue or be sued. It pays taxes as a separate entity.

In contrast to a partnership, in which the acts of the owners (partners) bind the partnership, the acts of corporate owners (stockholders) do not bind the corporation unless such owners are agents of the corporation. For example, if you owned shares of Nike stock, you would not have the right to purchase inventory for the company unless you were designated as an agent of the corporation.

Limited Liability of Stockholders

Since a corporation is a separate legal entity, creditors ordinarily have recourse only to corporate assets to satisfy their claims. The liability of stockholders is normally limited to their investment in the corporation. Creditors have no legal claim on the personal assets of the stockholders unless fraud has occurred. Thus, even in the event of bankruptcy of the corporation, stockholders’ losses are generally limited to the amount of capital they have invested in the corporation.

Transferable Ownership Rights

Ownership of a corporation is held in shares of capital stock, which are transferable units. Stockholders may dispose of part or all of their interest in a corporation simply by selling their stock. The transfer of an ownership interest in a partnership requires the consent of each partner. In contrast, the transfer of stock is entirely at the discretion of the stockholder. It does not require the approval of either the corporation or other stockholders.

The transfer of ownership rights among stockholders normally has no effect on the operating activities of the corporation. Nor does it affect the corporation’s assets, liabilities, and total stockholders’ equity. The transfer of ownership rights is a transaction between individual owners. The company does not participate in the transfer of these ownership rights after the original sale of the capital stock.

Ability to Acquire Capital

It is relatively easy for a corporation to obtain capital through the issuance of stock. Buying stock in a corporation is often attractive to an investor because a stockholder has limited liability and shares of stock are readily transferable. Also, numerous individuals can become stockholders by investing small amounts of money.

Transferable ownership rights

Ability to acquire capital

Continuous Life

The life of a corporation is stated in its charter. The life may be perpetual or it may be limited to a specific number of years. If it is limited, the company can extend the period of existence through renewal of the charter. Since a corporation is a separate legal entity, its continuance as a going concern is not affected by the withdrawal, death, or incapacity of a stockholder, employee, or officer. As a result, a successful corporation can have a continuous and perpetual life.

Corporation Management

Illustration 11-1

Corporation organization chart

board of directors. The board, in turn, formulates the operating policies for the company. The board also selects officers, such as a president and one or more vice presidents, to execute policy and to perform daily management functions. As a result of the Sarbanes-Oxley Act, the board is now required to monitor management’s actions more closely. Many feel that the failures at Enron and WorldCom could have been avoided by more diligent boards.

Illustration 11-1 depicts a typical organization chart showing the delegation of responsibility.

Stockholders

Chairman and

Board of Directors

President and

Chief Executive Officer

Ethics Note Managers who are not owners are often compensated based on the performance of the company. They thus may be tempted to exaggerate company performance by inflating income figures.

WKK Corp.

Stock exchange Federal requirements regulations

Government regulations

The chief executive officer (CEO) has overall responsibility for managing the business. As the organization chart shows, the CEO delegates responsibility to other officers. The chief accounting officer is the controller. The controller’s responsibilities are to (1) maintain the accounting records, (2) maintain an adequate system of internal control, and (3) prepare financial statements, tax returns, and internal reports. The treasurer has custody of the corporation’s funds and is responsible for maintaining the company’s cash position.

The organizational structure of a corporation enables a company to hire professional managers to run the business. On the other hand, the separation of ownership and management often reduces an owner’s ability to actively manage the company.

Government Regulations

A corporation is subject to numerous state and federal regulations. For example, state laws usually prescribe the requirements for issuing stock, the distributions of earnings permitted to stockholders, and acceptable methods for retiring stock. Federal securities laws govern the sale of capital stock to the general public. Also, most publicly held corporations are required to make extensive disclosure of their financial affairs to the Securities and Exchange Commission (SEC) through quarterly and annual reports. The Sarbanes-

Oxley Act increased the company’s responsibility for the accuracy of these reports. In addition, when a corporate stock is listed and traded on organized securities exchanges, the corporation must comply with the reporting requirements of these exchanges.