Chapter 5

Communicating and
Interpreting
Accounting Information

Players in the
Management
Management
Preparation
Accounting
Preparation
CEO, CFO,
CFO, Accounting
Accounting Staff
Staff
Communication CEO,
Guided
Guided by
by GAAP
GAAP
Process

5-2

Independent
Independent Auditors
Auditors
Verification
Verification
Partners,
Partners, Managers,
Managers, Staff
Staff
Guided
Guided by
by GAAS
GAAS

An
An unqualified
unqualified opinion
opinion states
states
that
that the
the financial
financial statements
statements are
are
fair
fair presentations
presentations in
in all
all material
material
respects
respects in
in conformity
conformity with
with
GAAP.
GAAP.
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Players in the
Management
Management
Preparation
Accounting
Preparation
CFO, CEO,
CEO, Accounting
Accounting Staff
Staff
Communication CFO,
Guided
Guided by
by GAAP
GAAP
Process

5-3

Independent
Independent Auditors
Auditors
Verification
Verification
Partners,
Partners, Managers,
Managers, Staff
Staff
Guided
Guided by
by GAAS
GAAS
Information
Information
Intermediaries
Intermediaries
Analysis
Analysis and
and Advice
Advice
Financial
Financial analysis,
analysis,
Information
Information services
services

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Financial
Financial analysts
analysts
make
make predictions
predictions
concerning
concerning
companies
companies future
future
earnings
earnings and
and stock
stock
prices.
prices.

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Players in the
Management
Management
Preparation
Accounting
Preparation
CFO, CEO,
CEO, Accounting
Accounting Staff
Staff
Communication CFO,
Guided
Guided by
by GAAP
GAAP
Process
Independent
Independent Auditors
Auditors
Verification
Verification
Partners,
Partners, Managers,
Managers, Staff
Staff
Guided
Guided by
by GAAS
GAAS
Information
Information
Intermediaries
Intermediaries
Analysis
Analysis and
and Advice
Advice
Financial
Financial analysis,
analysis,
Information
Information services
services

Government
Government
Regulators
Regulators
Verification
Verification
SEC
SEC Members
Members
Guided
Guided by
by SEC
SEC regs.
regs.
Users
Users
Analysis
Analysis and
and Decision
Decision
Investors,
Investors, Lenders,
Lenders, etc.
etc.

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Public
companies only

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Guiding Principles for

Communicating
Useful
Information
Primary Objective of External Financial Reporting

Primary Objective of External Financial Reporting

To
To provide
provide economic
economic information
information to
to external
external users
users
for
for decision
decision making.
making.
Primary
Primary Qualitative
Qualitative Characteristics
Characteristics
Relevance:
Relevance: Timely
Timely and
and Predictive
Predictive and
and Feedback
Feedback Value
Value
Reliability:
Reliability: Accurate,
Accurate, Unbiased,
Unbiased, and
and Verifiable
Verifiable
Secondary
Secondary Qualitative
Qualitative Characteristics
Characteristics
Comparability:
Comparability: Across
Across businesses
businesses
Consistency:
Consistency: Over
Over time
time

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Guiding Principles for

Communicating
Useful
Information
Primary Objective of External Financial Reporting

Primary Objective of External Financial Reporting

To
To provide
provide economic
economic information
information to
to external
external users
users
for
for decision
decision making.
making.

The full-disclosure principles requires . . .

Primary
Primary Qualitative
Qualitative Characteristics
Characteristics
1. A
complete
set
ofPredictive
financial
statements,
Relevance:
and
Relevance: Timely
Timely and
and Predictive
and Feedback
Feedback Value
Value
and Unbiased,
Reliability:
Reliability: Accurate,
Accurate,
Unbiased, and
and Verifiable
Verifiable

2.Notes to the financial statements

Secondary
Secondary Qualitative
Qualitative Characteristics
Characteristics
Comparability:
Comparability: Across
Across businesses
businesses
Consistency:
Consistency: Over
Over time
time
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Disclosure to investors
Press releases
Annual reports
Letter to stockholders from the CEO,
description of the firm philosophy,
products, successes and prospects for the
future
Quarterly reports

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5-8

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5-9

Current
Current assets
assets
are
are assets
assets that
that
will
will be
be turned
turned into
into
cash
cash or
or expire
expire
(be
(be used
used up)
up)
within
within the
the longer
longer
of
of one
one year
year or
or the
the
operating
operating cycle.
cycle.
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Property,
Property, plant
plant and
and
equipment
equipment includes
includes
assets
assets with
with useful
useful
lives
lives of
of more
more than
than
one
one year
year acquired
acquired
for
for use
use in
in the
the
business
business rather
rather
than
than for
for resale.
resale. The
The
amount
amount is
is reported
reported
net
net of
of accumulated
accumulated
depreciation
depreciation..
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Intangible
Intangible assets
assets
have
have no
no physical
physical
existence
existence and
and aa
long
long life.
life. They
They
include
include patents,
patents,
copyrights,
copyrights,
trademarks,
trademarks, etc.
etc.
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Lets now look

at the liability
section of a
classified
balance sheet.

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Long-term
Long-term liabilities
liabilities are
are debts
debts that
that have
have
maturity
maturity dates
dates extending
extending beyond
beyond one
one
year
year from
from the
the balance
balance sheet
sheet date.
date.
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Finally, we get
to the
stockholders
equity section
of a classified
balance sheet.

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Contributed
Contributed capital
capital is
is often
often shown
shown in
in
two
two separate
separate accounts
accounts .. .. ..
1.
1.Common
Common stock
stock
2.
2.Paid-in
Paid-in capital
capital
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Retained
Retained earnings
earnings is
is the
the total
total
earnings
earnings of
of the
the company
company less
less the
the
total
total dividends
dividends declared
declared since
since
inception
inception of
of operations.
operations.

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Companies often purchase shares of its own

common stock. This stock is said to be held in
the treasury and can be used to satisfy employee
stock purchase or option plans. Treasury shares
may also be used in connection with the
acquisition of another company.

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Classified Income Statement

General Format for the Classified Income Statement

Gross
Gross sales
sales minus any
discounts,
discounts, returns,
returns, and
and
allowances
allowances during
during the
the period.
period.
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Classified Income Statement

General Format for the Classified Income Statement

Cost
Cost of
of inventory
inventory sold.
sold.

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Classified Income Statement

General Format for the Classified Income Statement

Not
Not related
related to
to the
the companys primary
primary
operations.
operations. Usually includes interest income or
expense
expense and
and any
any gains or losses from the
retirement
retirement of
of equipment.
equipment.
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Classified Income Statement

In addition,
have
nonrecurring
items.
General companies
Format for the may
Classified
Income
Statement
These nonrecurring items may include:
1. Discontinued operations,
2. Extraordinary items,
3. Cumulative effect of changes in accounting methods.
These items are reported separately because they are
not useful in predicting future income of the company.

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Discontinued Operations
Sale
Sale or
or abandonment
abandonment of
of aa segment
segment of
of aa
business.
business.

Income
Income or
or loss
loss on
on
segments
segments operation
operation for
for
the
the period.
period.

Gain
Gain or
or loss
loss on
on
disposal
disposal of
of the
the
segment.
segment.

Show net of applicable taxes.

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Extraordinary Items

Unusual

Infrequent

Show net of applicable taxes.

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Cumulative Effect of Changes in

Accounting Methods

GAAP
GAAP
Method
Method

Change to
Alternative

GAAP
GAAP
Method
Method

The
The change
change must
must be
be to
to aa preferable
preferable
method
method and
and must
must be
be disclosed
disclosed in
in notes
notes
to
to financial
financial statements.
statements.

Show net of applicable taxes.

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Classified Income Statement

Now,
Now, lets
lets look
look at
at two
two common
common
formats
formats for
for presenting
presenting the
the
continuing
continuing operations
operations section.
section.
1.
1.Single-step
Single-step income
income statement
statement
2.
2.Multiple-step
Multiple-step income
income statement
statement

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In
In the
the single-step
single-step format
format,, all
all revenues,
revenues, income,
income,
and
and gains
gains are
are listed
listed first.
first.
Costs,
Costs, expenses,
expenses, and
and losses
losses are
are then
then subtracted
subtracted
from
from total
total revenues
revenues to
to get
get net
net income.
income.
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Cost of goods sold is shown along with a

separation of non-operating income and
expenses and non-recurring items.
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A nonrecurring
item that is
presented
separately after
income from
operations.
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Earnings Per Share

EPS =

Net Income Available to Common Shareholders

Weighted Average Number of Shares
Outstanding During the Reporting Period

Basic EPS

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Earnings Per Share

EPS =

Net Income Available to Common Shareholders

Weighted Average Number of Shares
Outstanding During the Reporting Period

Diluted EPS
Stock options, debt securities,
equity securities are assumed to
be converted into common stock
at the beginning of the period.
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Both
Both basic
basic and
and
diluted
diluted EPS
EPS are
are
reported
reported here.
here.

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Accounting-Based Executive Bonuses

Executives are frequently paid bonuses
based upon pretax earnings growth of
the company.
Pre-Tax Earnings
=
Growth Percent

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Current Year

Pretax Earnings

Last Year
Pretax Earnings

Last Year Pretax Earnings

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The End of Chapter 5

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