CHAPTER 2
A Further Look at Financial Statements

Chapter Preview

If you are thinking of purchasing Best Buy stock, or any stock, how can you decide what the shares are worth? If you manage Columbia Sportswear’s credit department, how should you determine whether to extend credit to a new customer? If you are a financial executive at Alphabet Inc. (Google), how do you decide whether your company is generating adequate cash to expand operations without borrowing? Your decision in each of these situations will be influenced by a variety of considerations. One of them should be your careful analysis of a company’s financial statements.

In this chapter, we take a closer look at the balance sheet and introduce some useful ways for evaluating the information provided by the financial statements. We also examine the financial reporting concepts underlying the financial statements. We begin by introducing the classified balance sheet.

Feature Story

Just Fooling Around?

Two early pioneers in providing investment information online to the masses were Tom and David Gardner, brothers who created an online investor website called The Motley Fool. The name comes from Shakespeare’s As You Like It. The fool in Shakespeare’s play was the only one who could speak unpleasant truths to kings and queens without being killed. Tom and David view themselves as 21st-century “fools,” revealing the “truths” of the stock market to the small investor, who they feel has been taken advantage of by Wall Street insiders.

The Motley Fool’s online bulletin board enables investors to exchange information and insights about companies. (Similar services are provided by TikTok, Twitter, Reddit, Facebook, and others.) Critics of these bulletin boards contend that they are simply high-tech rumor mills that cause investors to bid up stock prices to unreasonable levels. For example, the stock of PairGain Technologies jumped 32% in a single day as a result of a bogus takeover rumor on an investment bulletin board. Some observers are concerned that small investors—ironically, the very people the Gardner brothers are trying to help—will be hurt the most by misinformation and intentional scams.

Rather than getting swept away by rumors, investors must sort out the good information from the bad. One thing is certain—as information services such as The Motley Fool increase in number, gathering information will become even easier. Evaluating it will be the harder task.

Chapter Outline

LEARNING OBJECTIVES	REVIEW	PRACTICE
LO 1 Identify the sections of a classified balance sheet.	Current assets Long-term investments Property, plant, and equipment Intangible assets Current liabilities Long-term liabilities Stockholders’ equity	DO IT! 1a Assets Section of Classified Balance Sheet 1b Balance Sheet Classifications
LO 2 Use ratios to evaluate a company’s profitability, liquidity, and solvency.	Ratio analysis Using the income statement Using a classified balance sheet	DO IT! 2 Ratio Analysis
LO 3 Discuss financial reporting concepts.	The standard-setting environment Qualities of useful information Assumptions in financial reporting Principles in financial reporting Cost constraint	DO IT! 3 Financial Accounting Concepts and Principles
Go to the Review and Practice section at the end of the chapter for a targeted summary and practice applications with solutions. Visit Wiley Course Resources for additional tutorials and practice opportunities.

2.1 The Classified Balance Sheet

A balance sheet presents a snapshot of a company’s financial position at a point in time. It lists individual asset, liability, and stockholders’ equity items. To improve users’ understanding of a company’s financial position, companies often prepare what is referred to as a classified balance sheet instead.

A classified balance sheet groups together similar assets and similar liabilities, using a number of standard classifications and sections.
This is useful because items within a group have similar economic characteristics.

A classified balance sheet generally contains the standard classifications listed in Illustration 2.1.

ILLUSTRATION 2.1 Standard balance sheet classifications

Assets		Liabilities and Stockholders’ Equity
Current assets		Current liabilities
Long-term investments		Long-term liabilities
Property, plant, and equipment		Stockholders’ equity
Intangible assets

These groupings help financial statement readers determine such things as:

Whether the company has enough assets to pay its debts as they come due.
The claims of short- and long-term creditors on the company’s total assets.

Many of these groupings can be seen in the balance sheet of Franklin Corporation shown in Illustration 2.2 (see Helpful Hint). In the sections that follow, we explain each of these groupings.

Current Assets

Current assets are defined as follows.

Assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2.2, Franklin Corporation had current assets of $22,100.
For most businesses, the cutoff for classification as current assets is one year from the balance sheet date.

For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use the supplies in operations within one year.

Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year.

The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers.
For most businesses, this cycle takes less than a year, so they use a one-year cutoff.
But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year.

Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long-term.

ILLUSTRATION 2.2 Classified balance sheet

Franklin Corporation Balance Sheet October 31, 2025
	Assets
	Current assets
	Cash		$6,600
	Debt investments		2,000
	Accounts receivable		7,000
	Notes receivable		1,000
	Inventory		3,000
	Supplies		2,100
	Prepaid insurance		400
	Total current assets			$22,100
	Long-term investments
	Stock investments		5,200
	Investment in real estate		2,000	7,200
	Property, plant, and equipment
	Land		10,000
	Equipment	$24,000
	Less: Accumulated depreciation— equipment	5,000	19,000	29,000
	Intangible assets
	Patents			3,100
	Total assets			$61,400
	Liabilities and Stockholders’ Equity
	Current liabilities
	Notes payable		$11,000
	Accounts payable		2,100
	Unearned sales revenue		900
	Salaries and wages payable		1,600
	Interest payable		450
	Total current liabilities			$16,050
	Long-term liabilities
	Mortgage payable		10,000
	Notes payable		1,300
	Total long-term liabilities			11,300
	Total liabilities			27,350
	Stockholders’ equity
	Common stock		14,000
	Retained earnings		20,050
	Total stockholders’ equity			34,050
	Total liabilities and stockholders’ equity			$61,400

Companies list current assets in order of liquidity, that is, the order in which they expect to convert them into cash (follow this rule when doing your homework). Common types of current assets, listed in order of liquidity, are:

Cash.
Investments (such as short-term U.S. government securities).
Receivables (accounts receivable, notes receivable, and interest receivable).
Inventories.
Prepaid expenses (insurance and supplies).

Why are receivables considered more liquid than inventory? Inventory must be sold before it is converted to cash (and is often sold on account), whereas receivables are converted to cash upon collection.

As explained later in the chapter, a company’s current assets are important in assessing its short-term debt-paying ability.

Long-Term Investments

Long-term investments generally include the following (see Alternative Terminology).

Investments in stocks and bonds of other corporations that are held for more than one year.
Long-term assets such as land or buildings that a company is not currently using in its operating activities.
Long-term notes receivable.

In Illustration 2.2, Franklin Corporation reported total long-term investments of $7,200 on its balance sheet.

Property, Plant, and Equipment

Property, plant, and equipment is defined as follows.

Assets with relatively long useful lives that are currently used in operating the business (see Alternative Terminology).
This category includes land, buildings, equipment, delivery vehicles, and furniture.

In Illustration 2.2, Franklin Corporation reported property, plant, and equipment of $29,000.

Notice that in Illustration 2.2, Franklin Corporation subtracts $5,000 in Accumulated Depreciation—Equipment from the Equipment account. Depreciation is the systematic allocation of the cost of an asset to expense over number of years (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation, often referred to as book value. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset’s life.

In Illustration 2.2, Franklin Corporation reported accumulated depreciation of $5,000, so the book value of the equipment is $19,000 ($24,000 – $5,000). In your homework, present each accumulated depreciation account immediately below the related plant asset, as shown in Illustration 2.2 for Franklin Corporation.

Intangible Assets

Many companies have assets that do not have physical substance and yet often are very valuable:

We call these assets intangible assets (see Helpful Hint).
One common intangible is goodwill.
Other intangibles include patents, copyrights, and trademarks or trade names that give the company exclusive right of use for a specified period of time.

In Illustration 2.2, Franklin Corporation reported intangible assets of $3,100.

Investor Insight

Best Buy

I Heard It Through the Grapevine

To show how investor bulletin boards work, suppose that you had $10,000 to invest. You were considering Best Buy, the largest seller of electronics equipment in the United States. You scanned the Internet investor bulletin boards and found messages posted by two different investors. Here are excerpts from actual postings:

TMPVenus: “Where are the prospects for positive movement for this company? Poor margins, poor management, astronomical P/E!”

broachman: “I believe that this is a LONG TERM winner, and presently at a good price.”

One says sell, and one says buy. Which posting should you believe? If at that time you had taken “broachman’s” advice and purchased the stock, the $10,000 you invested would have been worth over $300,000 five years later. Best Buy was one of America’s best-performing stocks during that five-year period of time.

How much reliance should you place on information posted to investor bulletin boards when you are considering investing money?

Answer

Investor bulletin boards can provide some interesting ideas, but you should place very little weight on what you read there. You don’t know the background of the people that post information, nor do you know what motives they might have for posting the information. As can be seen in this example, it is not hard to find conflicting views on any position you might take on an investment. If you have an interest in investing, we encourage you to work hard in this course and subsequent courses in accounting and finance so that you are equipped to make informed decisions.

DO IT! 1a

Assets Section of Classified Balance Sheet

Baxter Hoffman recently received the following information related to Hoffman Corporation’s December 31, 2025, balance sheet.

Prepaid insurance	$ 2,300	Inventory	$3,400
Cash	800	Accumulated depreciation— equipment	2,700
Equipment	10,700	Accumulated depreciation— equipment	2,700
Debt investments (long-term)	2,100	Accounts receivable	1,100
		Trademarks	4,700

Prepare the assets section of Hoffman Corporation’s classified balance sheet.

ACTION PLAN

Present current assets first. Current assets are cash and other resources that the company expects to convert to cash or use up within one year.
Present current assets in the order in which the company expects to convert them into cash.
Subtract accumulated depreciation—equipment from equipment to determine net equipment.

Solution

Hoffman Corporation Balance Sheet (partial) December 31, 2025
	Assets
	Current assets
	Cash	$800
	Accounts receivable	1,100
	Inventory	3,400
	Prepaid insurance	2,300
	Total current assets		$ 7,600
	Long-term investments
	Debt investments		2,100
	Property, plant, and equipment
	Equipment	10,700
	Less: Accumulated depreciation—equipment	2,700	8,000
	Intangible assets
	Trademarks		4,700
	Total assets		$22,400

Related exercise material: BE2.2, DO IT! 2.1a, E2.3, and E2.4.

Current Liabilities

In the liabilities and stockholders’ equity section of the balance sheet, the first grouping is current liabilities.

Current liabilities are obligations that the company is to pay within the next year or operating cycle, whichever is longer.
Common examples are accounts payable, salaries and wages payable, notes payable, unearned revenue, interest payable, and income taxes payable.
Also included as current liabilities are current maturities of long-term obligations—payments to be made within a year of the balance sheet date on long-term obligations.

In Illustration 2.2, Franklin Corporation reported five different types of current liabilities, for a total of $16,050.

Long-Term Liabilities

Long-term liabilities (long-term debt) are:

Obligations that a company expects to pay after one year.
Liabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities.

Many companies report long-term debt maturing after one year as a single amount in the balance sheet and show the details of the debt in notes that accompany the financial statements. Others list the various types of long-term liabilities. In Illustration 2.2, Franklin Corporation reported long-term liabilities of $11,300.

Stockholders’ Equity

Stockholders’ equity consists of two parts: common stock and retained earnings.

Companies record as common stock the investments of assets into the business by the stockholders (see Alternative Terminology).
They record as retained earnings the income retained for use in the business.
These two parts, combined, make up stockholders’ equity on the balance sheet.

In Illustration 2.2, Franklin Corporation reported common stock of $14,000 and retained earnings of $20,050.

DO IT! 1b

Balance Sheet Classifications

The following financial statement items were taken from the financial statements of Callahan Corp.

______Salaries and wages payable	______Equipment
______Service revenue	______Accumulated depreciation—equipment
______Interest payable	______Accumulated depreciation—equipment
______Goodwill	______Depreciation expense
______Debt investments (short-term)	______Retained earnings
______Mortgage payable (due in 3 years)	______Unearned service revenue
______Investment in real estate

Match each of the items to its proper balance sheet classification, shown below. If the item would not appear on a balance sheet, use “NA.”

Current assets (CA)	Current liabilities (CL)
Long-term investments (LTI)	Long-term liabilities (LTL)
Property, plant, and equipment (PPE)	Stockholders’ equity (SE)
Intangible assets (IA)

ACTION PLAN

Analyze whether each financial statement item is an asset, liability, or stockholders’ equity item.
Determine if asset and liability items are current or long-term.

Solution

CL Salaries and wages payable	LTI Investment in real estate
NA Service revenue	PPE Equipment
CL Interest payable	PPE Accumulated depreciation—equipment
IA Goodwill	PPE Accumulated depreciation—equipment
CA Debt investments (short-term)	NA Depreciation expense
LTL Mortgage payable (due in 3 years)	SE Retained earnings
LTL Mortgage payable (due in 3 years)	CL Unearned service revenue

Related exercise material: BE2.1, BE2.2, DO IT! 2.1b, E2.1, E2.2, E2.3, E2.5, E2.6, E2.7, E2.8, and E2.9.

2.2 Analyzing the Financial Statements Using Ratios

We previously introduced the four financial statements. We discussed how these statements provide information about a company’s performance and financial position. Here, we extend this discussion by showing you specific tools that you can use to analyze financial statements in order to make a more meaningful evaluation of a company.

Ratio Analysis

Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. For analysis of the primary financial statements, we classify ratios as shown in Illustration 2.3.

Three illustrations depict the classifications of financial ratios, each displayed with a corresponding text. The first illustration on the left displays an equation that reads, Total revenue displayed by a hand holding a dollar sign minus Total Expenses displayed by a statement equals Net Income displayed by a dollar sign embossed on a coin. The corresponding text titled, Profitability Ratios, reads, Measure the income or operating success of a company for a given period of time. The second illustration on the left displays a balance scale. The left plate and the right plate weigh a dollar sign embossed on each coin. The left plate is lower than the right plate. The corresponding text titled, Liquidity Ratios, reads, Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. The third illustration on the left displays a company founded in 1966. The corresponding text titled, Solvency Ratios, reads, Measure the ability of the company to survive over a long period of time. — ILLUSTRATION 2.3 Financial ratio classifications

A single ratio by itself is not very meaningful. Accordingly, in this and the following chapters, we will use various comparisons to shed light on company performance:

Intracompany comparisons covering two years for the same company.
Industry-average comparisons based on average ratios for particular industries.
Intercompany comparisons based on comparisons with a competitor in the same industry.

Next, we use some ratios and comparisons to analyze the financial statements of Best Buy.

Using the Income Statement

Best Buy generates profits for its stockholders by selling electronics.

The income statement reveals how successful the company is at generating a profit from its sales.
The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses).

Illustration 2.4 shows a simplified income statement for Best Buy. From this income statement, we can see that Best Buy’s net income increased from $1,464 million to $1,541 million.

Real World — ILLUSTRATION 2.4 Best Buy’s income statement

hhgregg was a competitor of Best Buy. hhgregg was much smaller than Best Buy. At one time, hhgregg operated 228 stores in 20 states. Then, one year it reported a net loss of $54,879,000. The next year, it filed for bankruptcy. Just because a company has a net loss does not mean it is about to go bankrupt. However, because net losses are not sustainable over the long-term, they are worthy of investigation.

To evaluate the profitability of Best Buy, we will use ratio analysis. Profitability ratios, such as earnings per share, measure the operating success of a company for a given period of time.

Earnings per Share

Earnings per share (EPS) measures the net income earned on each share of common stock (see Decision Tools). Stockholders usually think in terms of the number of shares they own or plan to buy or sell, so stating net income earned as a per share amount provides a useful perspective for determining the investment return. Advanced accounting courses present more refined techniques for calculating earnings per share.

A basic approach for calculating earnings per share is to divide earnings available to common stockholders by weighted-average common shares outstanding during the year.
What is “earnings available to common stockholders”? It is an earnings amount calculated as net income less dividends paid on another type of stock, called preferred stock (Net income − Preferred dividends).

By comparing earnings per share of a single company over time, we can evaluate its relative earnings performance from the perspective of a stockholder—that is, on a per share basis. It is very important to note that comparisons of earnings per share across companies are not meaningful because of the wide variations in the numbers of shares of outstanding stock among companies.

Illustration 2.5 shows the earnings per share calculation for Best Buy in 2020 and 2019, based on the information presented below. To simplify our calculations, we assumed that any change in the number of shares of common stock for Best Buy occurred in the middle of the year.

(in millions)	2020	2019
Net income	$1,541	$1,464
Preferred dividends	–0–	–0–
Shares of common stock outstanding at beginning of year	266	283
Shares of common stock outstanding at end of year	256	266

ILLUSTRATION 2.5 Best Buy’s earnings per share

$Earnings per Share = \frac{Net Income - Preferred Dividends}{Weighted-Average Common Shares Outstanding}$
	($ and shares in millions)	2020	2019
	Earnings per share	$\frac{$ 1, 541 - $ 0}{(266 + 256) \div 2} = $ 5.90$	$\frac{$ 1, 464 - $ 0}{(283 + 266) \div 2} = $ 5.33$

Best Buy’s earnings per share increased from $5.33 to $5.90. This increase occurred because its net income increased and its outstanding shares decreased.

Using a Classified Balance Sheet

You can learn a lot about a company’s financial health by also evaluating the relationship between its various assets and liabilities. Illustration 2.6 provides a simplified balance sheet for Best Buy.

Liquidity

Suppose you are a banker at CitiGroup considering lending money to Best Buy, or you are a sales manager at Apple interested in selling computers and cell phones to Best Buy on credit.

You would be concerned about Best Buy’s liquidity—its ability to pay obligations expected to become due within the next year or operating cycle.
You would look closely at the relationship of its current assets to current liabilities.

Working Capital One measure of liquidity is working capital, which is the difference between the amounts of current assets and current liabilities (see Illustration 2.7).

ILLUSTRATION 2.7 Working capital

$Working Capital = Current Assets - Current Liabilities$

When current assets exceed current liabilities, working capital is positive. When this occurs, there is a greater likelihood that the company will pay its liabilities.
When working capital is negative, a company might not be able to pay short-term creditors, and the company might ultimately be forced into bankruptcy.

Best Buy had working capital in 2020 of $797 million ($8,857 million − $8,060 million).

Current Ratio Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. One liquidity ratio is the current ratio, computed as current assets divided by current liabilities (see Decision Tools).

The current ratio is a more dependable indicator of liquidity than working capital.
Two companies with the same amount of working capital may have significantly different current ratios.

Illustration 2.8 shows the 2020 and 2019 current ratios for Best Buy.

What does the ratio actually mean? Best Buy’s 2020 current ratio of 1.10:1 means that for every dollar of current liabilities, Best Buy has $1.10 of current assets. Best Buy’s current ratio decreased in 2020, which suggests its liquidity declined.

One potential weakness of the current ratio is that it does not take into account the composition of the current assets.

A satisfactory current ratio does not disclose whether a portion of the current assets is tied up in slow-moving inventory.
The composition of the current assets matters because a dollar of cash is more readily available to pay the bills than is a dollar of inventory.

ILLUSTRATION 2.8 Current ratio

$Current Ratio = \frac{Current Assets}{Current Liabilities}$
Best Buy ($ in millions)
	2020	2019
	$\frac{$ 8, 857}{$ 8, 060} = 1.10 : 1$	1.18:1

For example, suppose a company’s cash balance declined while its merchandise inventory increased substantially. If inventory increased because the company is having difficulty selling its products, then the current ratio might not fully reflect the reduction in the company’s liquidity (see Ethics Note).

Accounting Across the Organization

REL Consultancy Group

Can a Company Be Too Liquid?

There actually is a point where a company can be too liquid—that is, it can have too much working capital. While it is important to be liquid enough to be able to pay short-term bills as they come due, a company does not want to tie up its cash in extra inventory or receivables that are not earning the company money.

By one estimate from the REL Consultancy Group, the thousand largest U.S. companies had cumulative excess working capital of $1.017 trillion in a recent year. This was an 18% increase, which REL said represented a “deterioration in the management of operations.” Given that managers throughout a company are interested in improving profitability, it is clear that they should have an eye toward managing working capital. They need to aim for a “Goldilocks solution”—not too much, not too little, but just right.

More recently, a different study found that companies reduced the number of days it took to convert working capital into cash received from customers from 37.1 days down to 35.7 days.

Sources: Maxwell Murphy, “The Big Number,” Wall Street Journal (November 9, 2011); and Tatyana Shumsky and Nina Trentmann, “Finance Chiefs Look to Free Up Working Capital Ahead of Rate Increases,” Wall Street Journal (August 21, 2017).

What can various company managers do to ensure that working capital is managed efficiently to maximize net income?

Answer

Marketing and sales managers must understand that by extending generous repayment terms, they are expanding the company’s receivables balance and slowing the company’s cash flow. Production managers must strive to minimize the amount of excess inventory on hand. Managers must coordinate efforts to speed up the collection of receivables while also ensuring that the company pays its payables on time but never too early.

Solvency

Now suppose that instead of being a short-term creditor, you are interested in either buying Best Buy’s stock or extending the company a long-term loan.

Long-term creditors and stockholders are interested in a company’s solvency—its ability to pay interest as it comes due and to repay the balance of a debt due at its maturity.
Solvency ratios measure the ability of the company to survive over a long period of time.

Debt to Assets Ratio The debt to assets ratio is one measure of solvency. It is calculated by dividing total liabilities (both current and long-term) by total assets. It measures the percentage of total financing provided by creditors rather than stockholders (see Helpful Hint).

Debt financing is more risky than equity financing because debt must be repaid at specific points in time, whether the company is performing well or not.
Thus, the higher the percentage of debt financing, the riskier the company.

The higher the percentage of total liabilities (debt) to total assets, the greater the risk that the company may be unable to pay its debts as they come due. Illustration 2.9 shows the debt to assets ratios for Best Buy.

ILLUSTRATION 2.9 Debt to assets ratio

$Debt to Assets Ratio = \frac{Total Liabilities}{Total Assets}$
Best Buy ($ in millions)
	2020	2019
	$\frac{$12,112}{$15,591} = 78%$	74%

The 2020 ratio of 78% means that every dollar of assets was financed by 78 cents of debt. The higher the ratio, the more reliant the company is on debt financing.

A company with a high debt to assets ratio has a lower equity “buffer” available to creditors if the company becomes insolvent.
Thus, from the creditors’ point of view, a high ratio of debt to assets is undesirable (see Decision Tools).

The adequacy of this ratio is often judged in light of the company’s earnings. At one time, Best Buy and its competitor hhgregg relied on debt financing in a roughly equal fashion, but hhgregg went bankrupt. This is largely explained by the fact that hhgregg’s income was insufficient to pay its debt obligations as they came due. Generally, companies with relatively stable earnings, such as public utilities, can support higher debt to assets ratios than can cyclical companies with widely fluctuating earnings, such as many high-tech companies. In later chapters, you will learn additional ways to evaluate solvency.

Investor Insight

When Debt Is Good

Debt financing differs greatly across industries and companies. Here are some debt to assets ratios for selected companies in a recent year:

	Debt to Assets Ratio
Google	23%
Nike	41
Microsoft	48
ExxonMobil	48
Tesla	76

Discuss the difference in the debt to assets ratio of Google and Tesla.

Answer

Google has a lower debt to assets ratio than Tesla. Google is in a rapidly changing industry and thus should try to minimize the risk associated with increased debt. Also, because Google generates significant amounts of cash and has relatively less need for large investments in plant assets, it does not need to borrow a lot of cash. On the other hand, Tesla needs to make huge investments in plant assets. Thus, it has large borrowing needs.

DO IT! 2

Ratio Analysis

The following information is available for Ozone Inc.

	2025	2024
Current assets	$ 88,000	$ 60,800
Total assets	400,000	341,000
Current liabilities	40,000	38,000
Total liabilities	120,000	150,000
Net income	100,000	50,000
Preferred dividends	10,000	10,000
Common dividends	5,000	2,500

Common shares outstanding at beginning of year	60,000	40,000
Common shares outstanding at end of year	120,000	60,000

Compute earnings per share for 2025 and 2024 for Ozone, and comment on the change. Ozone’s primary competitor, Frost Corporation, had earnings per share of $2 in 2025. Comment on the difference in the ratios of the two companies.
Compute the current ratio and debt to assets ratio for each year, and comment on the changes.

ACTION PLAN

Use the formula for earnings per share (EPS): (Net income − Preferred dividends) ÷ Weighted-average common shares outstanding.
Use the formula for the current ratio: Current assets ÷ Current liabilities.
Use the formula for the debt to assets ratio: Total liabilities ÷ Total assets.

Solution

Earnings per share

2025 2024

$\frac{($ 100, 000 - $ 10, 000)}{(120, 000 + 60, 000) \div 2} = $ 1.00$ $\frac{($ 50, 000 - $ 10, 000)}{(60, 000 + 40, 000) \div 2} = $ 0.80$

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 2025. 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.
2025 2024

Current ratio $\frac{$88,000}{$40,000} = 2 .20:1$ $\frac{$60,800}{$38,000} = 1 .60:1$

Debt to assets ratio $\frac{$120,000}{$400,000} = 30%$ $\frac{$150,000}{$341,000} = 44%$

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 assets ratio, which declined from 44% to 30%.

Related exercise material: BE2.4, BE2.5, BE2.6, DO IT! 2.2, E2.11, E2.13, E2.14, and E2.15.

2.3 Financial Reporting Concepts

You have learned about the four financial statements and some basic ways to interpret those statements. In this section, we discuss concepts that underlie 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? Accounting professionals at Best Buy and all other U.S. companies get guidance from a set of accounting standards 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.

The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies.
The Financial Accounting Standards Board (FASB) is the primary accounting standard-setting body in the United States.
The Public Company Accounting Oversight Board (PCAOB) determines U.S. auditing standards and reviews the performance of auditing firms.
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 (see International Note). Foreign companies that wish to have their shares traded on U.S. stock exchanges do not have to prepare reports that conform with GAAP, as long as their reports conform with IFRS. Illustration 2.10 shows a global view of the accounting standard-setting bodies and guidance.

A map depicts a global view of the accounting standard-setting bodies and guidance. The key notes below the map read: F A S B, S E C, P C A O B with G A A P guidance, and I A S B and I F R S guidance. The data are as follows: F A S B, S E C, P C A O B with G A A P guidance: Alaska, and United States. I A S B and I F R S guidance: Greenland, Canada and its neighboring Islands, Mexico and continents of South America, Europe, Africa, Asia, and Australia. — ILLUSTRATION 2.10 World view of the standard-setting environment

International Insight

The Korean Discount

If you think that accounting standards don’t matter, consider past 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 adopted 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, and Japan, have either adopted international standards or created standards that are based on the international standards.

Source: Based on 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?

Answer

Transparency refers to the extent to which outsiders have knowledge regarding a company’s financial performance and financial position. If a company lacks transparency, its financial reports do not adequately inform investors of critical information that is needed to make investment decisions. If corporate transparency is increased, investors would be more willing to supply the financial capital that businesses need in order to grow, which would spur the country’s economic growth.

Qualities of Useful Information

The FASB and IASB use 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 2.11.

Enhancing Qualities

In addition to the two fundamental qualities of relevance and faithful representation, the FASB also describes a number of enhancing qualities of useful information. These include comparability, consistency, verifiability, timeliness, and understandability, as shown in Illustration 2.12.

Accounting Across the Organization

What Do These Companies Have in Common?

Another issue related to comparability is the accounting time period. An accounting period that is one-year long is called a fiscal year. But a fiscal year need not match the calendar year. For example, a company could end its fiscal year on April 30 rather than on December 31.

Why do companies choose the particular year-ends that they do? For example, why doesn’t every company use December 31 as its accounting year-end? Many companies choose to end their accounting year when inventory or operations are at a low point. This is advantageous because compiling accounting information requires much time and effort by managers, so they would rather do it when they aren’t as busy operating the business. Also, inventory is easier and less costly to count when its volume is low.

Some companies whose year-ends differ from December 31 are Delta Air Lines, June 30; The Walt Disney Company, September 30; and Dunkin’ Donuts, Inc., October 31. In the notes to its financial statements, Best Buy states that its accounting year-end is the Saturday nearest the end of January.

What problems might Best Buy’s year-end create for analysts?

Answer

First, if Best Buy’s competitors use a different year-end, when you compare their financial results you are not comparing performance over the same period of time or financial position at the same point in time. Also, by not picking a specific date, the number of weeks in Best Buy’s fiscal year will change. Some fiscal years will have 52 weeks; others will have 53 weeks.

Assumptions in Financial Reporting

To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 2.13 (see Ethics Note). These include assumptions about the monetary unit, economic entity, periodicity, and going concern.

Principles in Financial Reporting

Measurement Principles

GAAP generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.

Historical Cost Principle The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. For example, if land that was purchased for $30,000 increases in value to $40,000, it continues to be reported at $30,000.

Fair Value Principle The fair value principle indicates that assets and liabilities should be reported at fair value (the price that would be received if an asset was sold or the amount that would be required to be paid to settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets.

In choosing between cost and fair value, the FASB uses two qualities that make accounting information useful for decision-making—relevance and faithful representation.

In determining which measurement principle to use, the FASB weighs the factual nature of cost figures versus the relevance of fair value.
In general, the FASB indicates that most assets must follow the historical cost principle because market values may not be representationally faithful.
Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied.

Full Disclosure Principle

The full disclosure principle requires that companies disclose sufficient details regarding circumstances and events that would make a difference to financial statement users. If an important item cannot reasonably be reported directly in one of the four types of financial statements, then it should be discussed in notes that accompany the statements.

Cost Constraint

Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard-setters consider the cost constraint. It weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.

Illustration 2.14 summarizes aspects of the conceptual framework.

An illustration shows a balance scale. The left plate is labeled cost and the right plate is labeled benefits. The left plate is lower than the right plate.

ILLUSTRATION 2.14 Summary of conceptual framework

Objective of Financial Reporting
	To provide financial information that is useful to existing and potential investors and creditors in making decisions about providing resources to the company.
Qualitative Characteristics of Useful Financial Information
	Fundamental Qualitative Characteristics		Enhancing Qualitative Characteristics
	1. Relevance Predictive value Confirmatory value Materiality	2. Faithful representation Complete Neutral Free from material error	Comparability Verifiability Timeliness Understandability
	Assumptions		Principles
	Monetary unit Economic entity Periodicity Going concern		Measurement Historical cost Fair value Full disclosure
Cost Constraint

DO IT! 3

Financial Accounting Concepts and Principles

The following items guide the FASB when it creates accounting standards.

Relevance	Periodicity assumption
Faithful representation	Going concern assumption
Comparability	Historical cost principle
Consistency	Full disclosure principle
Monetary unit assumption	Materiality
Economic entity assumption

Match each item above with a description below.

______Ability to easily evaluate one company’s results relative to another’s.
______Belief that a company will continue to operate for the foreseeable future.
______The judgment concerning whether omitting or misstating an item could influence the decision of a financial statement user.
______The reporting of sufficient details regarding circumstances and events that would make a difference to financial statement users.
______The practice of preparing financial statements at regular intervals.
______The quality of information that indicates the information makes a difference in a decision.
______A belief that items should be reported on the balance sheet at the price that was paid to acquire the item.
______A company’s use of the same accounting principles and methods from year to year.
______Tracing accounting events to particular companies.
______The desire to minimize errors and bias in financial statements.
______Reporting only those things that can be measured in dollars.

ACTION PLAN

Understand the need for conceptual guidelines in accounting.
List the characteristics of useful financial information.
Review the assumptions, principles, and constraint that comprise the guidelines in accounting.

Solution

Comparability
Going concern assumption
Materiality
Full disclosure principle
Periodicity assumption
Relevance
Historical cost principle
Consistency
Economic entity assumption
Faithful representation
Monetary unit assumption

Related exercise material: BE2.9, BE2.10, BE2.11, DO IT! 2.3, E2.16, E2.17, E2.18, and E2.19.

USING THE DECISION TOOLS

Tweeter Home Entertainment

In this chapter, we evaluated a home electronics giant, Best Buy. Tweeter Home Entertainment sold consumer electronics products from 154 stores on the East Coast under various names. It specialized in products with high-end features. Tweeter filed for bankruptcy in June 2007 and was acquired by another company in July 2007. Financial data for Tweeter, prior to its bankruptcy, are provided below.

	September 30
(amounts in millions)	2006	2005
Current assets	$146.4	$158.2
Total assets	258.6	284.0
Current liabilities	107.1	119.0
Total liabilities	190.4	201.1
Total common stockholders’ equity	68.2	82.9
Net income (loss)	(16.5)	(74.4)
Dividends paid	0	0
Weighted-average shares of common stock (millions)	25.2	24.6

Instructions

Using the data provided, answer the following questions and discuss how these results might have provided an indication of Tweeter’s financial troubles.

Calculate the current ratio for Tweeter for 2006 and 2005 and discuss its liquidity position.
Calculate the debt to assets ratio for Tweeter for 2006 and 2005 and discuss its solvency.
Calculate the earnings per share for Tweeter for 2006 and 2005, and discuss its change in profitability.
Best Buy’s accounting year-end was February 28, 2006; Tweeter’s was September 30, 2006. How does this difference affect your ability to compare their profitability?

Solution

Current ratio:

2006: $146.4 ÷ $107.1 = 1.37:1

2005: $158.2 ÷ $119.0 = 1.33:1

Tweeter’s liquidity improved slightly from 2005 to 2006, but in both years it would most likely have been considered inadequate. In 2006, Tweeter had only $1.37 in current assets for every dollar of current liabilities. Sometimes larger companies, such as Best Buy, can function with lower current ratios because they have alternative sources of working capital. But a company of Tweeter’s size would normally want a higher ratio.
Debt to assets ratio:

2006: $190.4 ÷ $258.6 = 73.6%

2005: $201.1 ÷ $284.0 = 70.8%

Tweeter’s solvency, as measured by its debt to assets ratio, declined from 2005 to 2006. Its ratio of 73.6% meant that every dollar of assets was financed by 73.6 cents of debt. For a retailer, this is extremely high reliance on debt. This low solvency suggests Tweeter’s ability to meet its debt payments was questionable.
Loss per share:

2006: −$16.5 ÷ 25.2 = −$0.65 per share

2005: −$74.4 ÷ 24.6 = −$3.02 per share

Tweeter’s loss per share declined substantially. However, this was little consolation for its shareholders, who experienced losses in previous years as well. The company’s lack of profitability, combined with its poor liquidity and solvency, increased the likelihood that it would eventually file for bankruptcy.
Tweeter’s income statement covers 7 months not covered by Best Buy’s. Suppose that the economy changed dramatically during this 7-month period, either improving or declining. This change in the economy would be reflected in Tweeter’s income statement but would not be reflected in Best Buy’s income statement until the following March, thus reducing the usefulness of a comparison of the income statements of the two companies.

Review and Practice

Learning Objectives Review

In a classified balance sheet, companies classify assets as current assets; long-term investments; property, plant, and equipment; and intangibles. They classify liabilities as either current or long-term. A stockholders’ equity section shows common stock and retained earnings.

Ratio analysis expresses the relationship among selected items of financial statement data. Profitability ratios, such as earnings per share (EPS), measure aspects of the operating success of a company for a given period of time.

Liquidity ratios, such as the current ratio, measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. Solvency ratios, such as the debt to assets ratio, measure the ability of a company to survive over a long period.

Generally accepted accounting principles are a set of rules and practices recognized as a general guide for financial reporting purposes. The basic objective of financial reporting is to provide information that is useful for decision-making.

To be judged useful, information should have the primary characteristics of relevance and faithful representation. In addition, useful information is comparable, consistent, verifiable, timely, and understandable.

The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption states that economic events can be identified with a particular unit of accountability. The periodicity assumption states that the economic life of a business can be divided into artificial time periods and that meaningful accounting reports can be prepared for each period. The going concern assumption states that the company will continue in operation long enough to carry out its existing objectives and commitments.

The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The full disclosure principle requires that companies disclose sufficient details regarding circumstances and events that would make a difference to financial statement users.

The cost constraint weighs the cost that companies incur to provide a type of information against its benefit to financial statement users.

Decision Tools Review

Decision Checkpoints	Info Needed for Decision	Tool to Use for Decision	How to Evaluate Results
How does the company’s earnings performance compare with that of previous years?	Net income available to common stockholders and weighted-average common shares outstanding	$Earnings per share = \frac{Net income – Preferred dividends}{Weighted-average common shares outstanding}$	A higher measure suggests improved performance, although the number is subject to manipulation. Values should not be compared across companies.
Can the company meet its near-term obligations?	Current assets and current liabilities	$Current ratio = \frac{Current assets}{Current liabilities}$	Higher ratio suggests favorable liquidity.
Can the company meet its long-term obligations?	Total liabilities and total assets	$Debt to assets ratio = \frac{Total liabilities}{Total assetss}$	Lower value suggests favorable solvency.

Glossary Review

Classified balance sheet: A balance sheet that groups together similar assets and similar liabilities, using a number of standard classifications and sections.
Comparability: Ability to compare the accounting information of different companies because they use the same accounting principles.
Consistency: Use of the same accounting principles and methods from year to year within a company.
Cost constraint: Constraint that weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.
Current assets: Assets that companies expect to convert to cash or use up within one year or the operating cycle, whichever is longer.
Current liabilities: Obligations that a company expects to pay within the next year or operating cycle, whichever is longer.
Current ratio: A measure of liquidity computed as current assets divided by current liabilities.
Debt to assets ratio: A measure of solvency calculated as total liabilities divided by total assets. It measures the percentage of total financing provided by creditors.
Earnings per share (EPS): A measure of the net income earned on each share of common stock; computed as net income minus preferred dividends divided by the weighted-average number of common shares outstanding during the year.
Economic entity assumption: An assumption that every economic entity can be separately identified and accounted for.
Fair value principle: Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).
Faithful representation: Information that accurately depicts what really happened.
Financial Accounting Standards Board (FASB): The primary accounting standard-setting body in the United States.
Full disclosure principle: Accounting principle that dictates that companies disclose sufficient details regarding circumstances and events that would make a difference to financial statement users.
Generally accepted accounting principles (GAAP): A set of accounting standards that have substantial authoritative support and which guide accounting professionals.
Going concern assumption: The assumption that the company will continue in operation for the foreseeable future.
Historical cost principle: An accounting principle that states that companies should record assets at their cost.
Intangible assets: Assets that do not have physical substance.
International Accounting Standards Board (IASB): An accounting standard-setting body that issues standards adopted by many countries outside of the United States.
International Financial Reporting Standards (IFRS): Accounting standards, issued by the IASB, that have been adopted by many countries outside of the United States.
Liquidity: The ability of a company to pay obligations that are expected to become due within the next year or operating cycle.
Liquidity ratios: Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Long-term investments: Generally, (1) investments in stocks and bonds of other corporations that companies hold for more than one year; (2) long-term assets, such as land and buildings, not currently being used in the company’s operations; and (3) long-term notes receivable.
Long-term liabilities (long-term debt): Obligations that a company expects to pay after one year.
Materiality: Whether omitting or misstating an item could influence the decision of a financial statement user.
Monetary unit assumption: An assumption that requires that only those things that can be expressed in money are included in the accounting records.
Operating cycle: The average time required to purchase inventory, sell it on account, and then collect cash from customers—that is, go from cash to cash.
Periodicity assumption: An assumption that the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business.
Profitability ratios: Measures of the operating success of a company for a given period of time.
Property, plant, and equipment: Assets with relatively long useful lives that are currently used in operating the business.
Public Company Accounting Oversight Board (PCAOB): The group charged with determining auditing standards and reviewing the performance of auditing firms.
Ratio: An expression of the mathematical relationship between one quantity and another.
Ratio analysis: A technique that expresses the relationship among selected items of financial statement data.
Relevance: The quality of information that indicates the information makes a difference in a decision.
Securities and Exchange Commission (SEC): The agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies.
Solvency: The ability of a company to pay interest as it comes due and to repay the balance of debt due at its maturity.
Solvency ratios: Measures of the ability of the company to survive over a long period of time.
Timely: Information that is available to decision-makers before it loses its capacity to influence decisions.
Understandability: Information presented in a clear and concise fashion so that users can interpret it and comprehend its meaning.
Verifiable: The quality of information that occurs when independent observers, using the same methods, obtain similar results.
Working capital: The difference between the amounts of current assets and current liabilities.

Practice Multiple-Choice Questions

1. (LO 1) In a classified balance sheet, assets are usually classified as:

current assets; long-term assets; property, plant, and equipment; and intangible assets.
current assets; long-term investments; property, plant, and equipment; and common stock.
current assets; long-term investments; tangible assets; and intangible assets.
current assets; long-term investments; property, plant, and equipment; and intangible assets.

Answer

d. Assets are classified as current assets; long-term investments; property, plant and equipment; and intangible assets. The other choices are incorrect because (a) long-term assets includes long-term investments; property, plant, and equipment; and intangible assets; (b) common stock refers to the equity of the firm and is not an asset; and (c) while tangible assets describes property, plant, and equipment, it is better to use the more common terminology of property, plant, and equipment.

2. (LO 1) Current assets are listed:

by order of expected conversion to cash.
by importance.
by longevity.
alphabetically.

Answer

a. Current assets should be listed by order of expected conversion to cash (liquidity), not (b) by importance, (c) by longevity, or (d) alphabetically.

3. (LO 1) The correct order of presentation in a classified balance sheet for the following current assets is:

accounts receivable, cash, prepaid insurance, inventory.
cash, inventory, accounts receivable, prepaid insurance.
cash, accounts receivable, inventory, prepaid insurance.
inventory, cash, accounts receivable, prepaid insurance.

Answer

c. The correct order of presentation for current assets is cash, accounts receivable, inventory, and then prepaid insurance. The other choices are therefore incorrect.

4. (LO 1) A company has purchased a tract of land. It expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. The land should be reported as:

property, plant, and equipment.
land expense.
a long-term investment.
an intangible asset.

Answer

c. Land or buildings that are currently not used in operations are considered to be long-term investments. The other choices are incorrect because (a) this classification is for property, plant, and equipment used in operations; (b) land is never expensed; and (d) intangible assets have no physical existence and are used in the production of income.

5. (LO 1) The balance in retained earnings is not affected by:

net income.
net loss.
issuance of common stock.
dividends.

Answer

c. Issuance of common stock has no impact on retained earnings. The other choices are incorrect because (a) net income increases retained earnings, (b) net loss decreases retained earnings, and (d) dividends decrease retained earnings.

6. (LO 2) Which is an indicator of profitability?

Current ratio.
Earnings per share.
Debt to assets ratio.
Total assets.

Answer

b. Earnings per share is a measure of profitability. The other choices are incorrect because (a) the current ratio is a measure of liquidity, (c) the debt to assets ratio is a measure of solvency, and (d) total assets is a measure of size.

7. (LO 2) For 2025, Spanos Corporation reported net income $26,000, net sales $400,000, and weighted-average common shares outstanding 4,000. There were preferred dividends of $2,000. What was the 2025 earnings per share?

$6.00.
$6.50.
$99.50.
$100.00.

Answer

a. Earnings per share = Net income ($26,000) less Preferred dividends ($2,000) divided by Weighted-average common shares outstanding (4,000) = $6.00 per share, not (b) $6.50, (c) $99.50, or (d) $100.00.

8. (LO 2) Which of these measures is an evaluation of a company’s ability to pay current liabilities?

Earnings per share.
Current ratio.
Both earnings per share and current ratio.
None of the answer choices is correct.

Answer

b. The current ratio measures liquidity. Higher current ratios indicate higher liquidity. The other choices are incorrect because (a) earnings per share is a measure of a firm’s profitability, not its ability to pay its current liabilities; (c) one of these answers is incorrect; and (d) there is a correct answer.

9. (LO 2) The following ratios are available for Reilly Inc. and O’Hare Inc.

	Current Ratio	Debt to Assets Ratio	Earnings per Share
Reilly Inc.	2:1	75%	$3.50
O’Hare Inc.	1.5:1	40%	$2.75

Compared to O’Hare Inc., Reilly Inc. has:

higher liquidity, higher solvency, and higher profitability.
lower liquidity, higher solvency, and higher profitability.
higher liquidity, lower solvency, and higher profitability.
higher liquidity and lower solvency, but profitability cannot be compared based on information provided.

Answer

d. Reilly Inc. has higher liquidity as it has a higher current ratio, and lower solvency due to its higher debt to assets ratio. However, profitability cannot be compared across companies using earnings per share because of the wide variations in the number of shares of common stock of different companies. The other choices are therefore incorrect.

10. (LO 2) Companies that can support higher debt to assets ratios are characterized by having:

stable earnings.
fluctuating earnings.
few plant assets.
low amounts of receivables.

Answer

a. In order to meet debt payments as they come due, a company must have a stable earnings stream. The other choices are incorrect as they do not address the ability to meet debt payments as they come due.

11. (LO 3) Generally accepted accounting principles are:

a set of standards and rules that are recognized as a general guide for financial reporting.
usually established by the Internal Revenue Service.
the guidelines used to resolve ethical dilemmas.
fundamental truths that can be derived from the laws of nature.

Answer

a. All 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. The other choices are incorrect because GAAP is (b) not established by the Internal Revenue Service, (c) not intended to provide guidance in resolving ethical dilemmas, or (d) created by people and can evolve over time, unlike laws of nature, such as those in physics and chemistry.

12. (LO 3) What organization issues U.S. accounting standards?

Financial Accounting Standards Board.
International Accounting Standards Committee.
International Auditing Standards Committee.
None of the answer choices is correct.

Answer

a. The Financial Accounting Standards Board (FASB) is the organization that issues U.S. accounting standards, not the (b) International Accounting Standards Committee or (c) International Auditing Standards Committee. Choice (d) is wrong as there is a correct answer.

13. (LO 3) What is the primary criterion by which accounting information can be judged?

Consistency.
Predictive value.
Usefulness for decision-making.
Comparability.

Answer

c. Usefulness for decision-making is the primary criterion by which accounting information can be judged. The other choices are incorrect because (a) consistency, (b) predictive value, and (d) comparability all help to make accounting information more useful but are not the primary criterion by which accounting information is judged.

14. (LO 3) Neutrality is an ingredient of:

	Faithful Representation	Relevance
a.	Yes	Yes
b.	No	No
c.	Yes	No
d.	No	Yes

Answer

c. Neutrality is an ingredient of faithful representation but not relevance. The other choices are therefore incorrect.

15. (LO 3) The characteristic of information that evaluates whether omitting or misstating an item could influence the decision of a financial statement user.

Comparability.
Materiality.
Cost.
Consistency.

Answer

b. Materiality evaluates whether omitting or misstating an item could influence the decision of a financial statement user, not (a) comparability, (c) cost, or (d) consistency.

Practice Brief Exercises

Prepare the current assets section of a balance sheet.

1. (LO 1) A list of financial statement items for Miguel Company includes the following: Accounts Receivable $25,000, Prepaid Insurance $7,000, Cash $8,000, Supplies $11,000, and Stock Investments (short-term) $14,000. Prepare the current assets section of the balance sheet, listing the accounts in proper sequence.

Solution

Miguel Company Balance Sheet (partial)
	Current assets
	Cash	$ 8,000
	Stock investments	14,000
	Accounts receivable	25,000
	Supplies	11,000
	Prepaid insurance	7,000
	Total current assets	$65,000

Classify accounts on balance sheet.

2. (LO 1) The following are the major balance sheet classifications:

Current assets (CA)	Current liabilities (CL)
Long-term investments (LTI)	Long-term liabilities (LTL)
Property, plant, and equipment (PPE)	Common stock (CS)
Intangible assets (IA)	Retained earnings (RE)

Match each of the following accounts to its proper balance sheet classification.

_____Prepaid insurance	_____Unearned service revenue
_____Notes payable (short-term)	_____Debt investments (short-term)
_____Equipment	_____Accumulated depreciation—equipment
_____Mortgage payable	_____Stock investments (long-term)
_____Copyrights	_____Salaries and wages payable

Solution

CA Prepaid insurance	CL Unearned service revenue
CL Notes payable (short-term)	CA Debt investments (short-term)
PPE Equipment	PPE Accumulated depreciation—equipment
LTL Mortgage payable	LTI Stock investments (long-term)
IA Copyrights	CL Salaries and wages payable

Calculate liquidity and solvency ratios.

3. (LO 2) Maison Inc. reported the following selected information at December 31.

	2025
Total current assets	$ 45,584
Total assets	278,000
Total current liabilities	32,560
Total liabilities	189,040

Calculate (a) the current ratio and (b) the debt to assets ratio for December 31, 2025.

Solution

$Current ratio = \frac{Current assets}{Current liabilities} = \frac{$45,584}{$32,560} = 1 .40:1$
$Debt to assets ratio = \frac{Total liabilities}{Total assets} = \frac{$189,040}{$278,000} = 68 .0%$

Practice Exercises

Prepare assets section of a classified balance sheet.

1. (LO 1) Suppose the following information (in thousands of dollars) is available for H. J. Heinz Company—famous for ketchup and other fine food products—for the year ended April 30, 2025.

Prepaid insurance	$ 168,182	Buildings	$4,344,269
Land	56,007	Cash	617,687
Goodwill	4,411,521	Accounts receivable	1,161,481
Trademarks	723,243	Accumulated depreciation—buildings	2,295,563
Inventory	1,378,216	Accumulated depreciation—buildings	2,295,563

Instructions

Prepare the assets section of a classified balance sheet, listing the items in proper sequence and including a statement heading.

Solution

H. J. Heinz Company Balance Sheet (partial) April 30, 2025 (in thousands)
	Assets
	Current assets
	Cash		$617,687
	Accounts receivable		1,161,481
	Inventory		1,378,216
	Prepaid insurance		168,182
	Total current assets			$ 3,325,566
	Property, plant, and equipment
	Land		56,007
	Buildings	$4,344,269
	Less: Accumulated depr.—buildings	2,295,563	2,048,706	2,104,713
	Intangible assets
	Goodwill		4,411,521
	Trademarks		723,243	5,134,764
	Total assets			$10,565,043

Compute and interpret various ratios.

2. (LO 2) Suppose the following data were taken from the 2025 and 2024 financial statements of American Eagle Outfitters. (All dollars are in thousands.)

	2025	2024
Current assets	$1,020,834	$1,189,108
Total assets	1,867,680	1,979,558
Current liabilities	376,178	464,618
Total liabilities	527,216	562,246
Net income	400,019	387,359
Dividends paid on common stock	80,796	61,521
Weighted-average common shares outstanding	216,119	222,662

Instructions

Perform each of the following.

Calculate the current ratio for each year.
Calculate earnings per share for each year.
Calculate the debt to assets ratio for each year.
Discuss American Eagle’s solvency in 2025 versus 2024.

Solution

			2025	2024
a.		Current ratio	$\frac{$1,020,834}{$376,178} = 2 .71:1$	$\frac{$1,189,108}{$464,618} = 2 .56:1$
b.		Earning per share	$\frac{$400,019}{216,119} = $1 .85$	$\frac{$387,359}{222,662} = $1 .74$
c.		Debt to assets ratio	$\frac{$527,216}{$1,867,680} = 28 .2%$	$\frac{$562,246}{$1,979,558} = 28 .4%$
d.	American Eagle’s debt to assets ratio decreased slightly from 28.4% for 2024 to 28.2% for 2025, indicating a very small increase in solvency for 2025.

Practice Problem

Prepare financial statements.

(LO 1) Listed here are items taken from the income statement and balance sheet of Bargain Electronics, Inc. for the year ended December 31, 2025. Certain items have been combined for simplification. (Amounts are given in thousands.)

Notes payable (due in 3 years)	$50.5
Cash	141.1
Salaries and wages expense	2,933.6
Common stock	454.9
Accounts payable	922.2
Accounts receivable	723.3
Accumulated depreciation—equipment	110.0
Equipment	1,031.0
Cost of goods sold	9,501.4
Income taxes payable	7.2
Interest expense	1.5
Mortgage payable	451.5
Retained earnings (December 31, 2025)	1,336.3
Inventory	1,636.5
Sales revenue	12,456.9
Debt investments (short-term)	382.6
Income tax expense	30.5
Goodwill	202.7
Notes payable (due in 6 months)	784.6

Instructions

Prepare an income statement and a classified balance sheet using the items listed. Do not use any item more than once.

Solution

Bargain Electronics, Inc. Income Statement For the Year Ended December 31, 2025 (in thousands)
	Revenues
	Sales revenue		$12,456.9
	Expenses
	Cost of goods sold	$9,501.4
	Salaries and wages expense	2,933.6
	Interest expense	1.5
	Income tax expense	30.5
	Total expenses		12,467.0
	Net loss		$(10.1)

Bargain Electronics, Inc. Balance Sheet December 31, 2025 (in thousands)
	Assets
	Current assets
	Cash	$141.1
	Debt investments	382.6
	Accounts receivable	723.3
	Inventory	1,636.5
	Total current assets		$2,883.5
	Property, plant and equipment
	Equipment	1,031.0
	Less: Accumulated depreciation—equipment	110.0	921.0
	Intangible assets
	Goodwill		202.7
	Total assets		$4,007.2
	Liabilities and Stockholders’ Equity
	Current liabilities
	Notes payable	$784.6
	Accounts payable	922.2
	Income taxes payable	7.2
	Total current liabilities		$1,714.0
	Long-term liabilities
	Mortgage payable	451.5
	Notes payable	50.5	502.0
	Total liabilities		2,216.0
	Stockholders’ equity
	Common stock	454.9
	Retained earnings	1,336.3
	Total stockholders’ equity		1,791.2
	Total liabilities and stockholders’ equity		$4,007.2

Questions

1. What is meant by the term operating cycle?

2. Define current assets. What basis is used for ordering individual items within the current assets section?

3. Distinguish between long-term investments and property, plant, and equipment.

4. How do current liabilities differ from long-term liabilities?

5. Identify the two parts of stockholders’ equity in a corporation and indicate the purpose of each.

Geena Lowe believes that the analysis of financial statements is directed at two characteristics of a company: liquidity and profitability. Is Geena correct? Explain.
Are short-term creditors, long-term creditors, and stockholders primarily interested in the same characteristics of a company? Explain.

7. Name ratios useful in assessing (a) liquidity, (b) solvency, and (c) profitability.

8. Tom Dawes, the founder of Footwear Inc., needs to raise $500,000 to expand his company’s operations. He has been told that raising the money through debt will increase the riskiness of his company much more than issuing stock. He doesn’t understand why this is true. Explain it to him.

9. What do these classes of ratios measure?

Liquidity ratios.
Profitability ratios.
Solvency ratios.

10. Holding all other factors constant, indicate whether each of the following signals generally good or bad news about a company.

Increase in earnings per share.
Increase in the current ratio.
Increase in the debt to assets ratio.

11. Which ratio or ratios from this chapter do you think should be of greatest interest to:

a pension fund considering investing in a corporation’s 20-year bonds?
a bank contemplating a short-term loan?
an investor in common stock?

12.

What are generally accepted accounting principles (GAAP)?
What body provides authoritative support for GAAP?

13.

What is the primary objective of financial reporting?
Identify the characteristics of useful accounting information.

14. Merle Hawkins, the president of Pathway Company, is pleased. Pathway substantially increased its net income in 2025 while keeping its unit inventory relatively the same. Jon Dietz, chief accountant, cautions Merle, however. Dietz says that since Pathway changed its method of inventory valuation, there is a consistency problem and it is difficult to determine whether Pathway is better off. Is Dietz correct? Why or why not?

15. What is the distinction between comparability and consistency?

16. Describe the constraint inherent in the presentation of accounting information.

17. Your roommate believes that accounting standards are uniform throughout the world. Is your roommate correct? Explain.

18. Wanda Roberts is president of Best Texts. She has no accounting background. Wanda cannot understand why fair value is not used as the basis for all accounting measurement and reporting. Discuss.

19. What is the economic entity assumption? Give an example of its violation.

20. What was Apple’s largest current asset, largest current liability, and largest item under “Assets” at September 26, 2020?

Brief Exercises

Classify accounts on balance sheet.

BE2.1 (LO 1), K The following are the major balance sheet classifications:

Current assets (CA)	Current liabilities (CL)
Long-term investments (LTI)	Long-term liabilities (LTL)
Property, plant, and equipment (PPE)	Common stock (CS)
Intangible assets (IA)	Retained earnings (RE)

Match each of the following accounts to its proper balance sheet classification.

_____Accounts payable	_____Buildings
_____Accounts receivable	_____Cash
_____Accumulated depreciation	_____Goodwill
_____Income taxes payable	_____Inventory
_____Investment in long-term bonds	_____Patents
_____Land	_____Supplies

Identify the order of asset classifications.

BE2.2 (LO 1), K Place a number, 1 through 7, in front of each of the following balance sheet categories to designate the order in which they are to be presented in a classified balance sheet.

_____Long-term investments	_____Current assets
_____Current liabilities	_____Long-term liabilities
_____Stockholders’ equity	_____Property, plant, and equipment
_____Intangible assets

Prepare the current assets section of a balance sheet.

BE2.3 (LO 1), AP A list of financial statement items for Chin Company includes the following: accounts receivable $14,000, prepaid insurance $2,600, cash $10,400, supplies $3,800, and debt investments (short-term) $8,200. Prepare the current assets section of the balance sheet listing the items in the proper sequence.

Compute earnings per share.

BE2.4 (LO 2), AP The following information (in millions of dollars) is available for L Brands for a recent year: sales revenue $9,043, net income $220, preferred dividend $0, and weighted-average common shares outstanding 333 million. Compute the earnings per share for L Brands.

Calculate liquidity ratios.

BE2.5 (LO 2), AP These selected condensed data are taken from a recent balance sheet of Bob Evans Farms (in millions of dollars).

Cash	$29.3
Accounts receivable	20.5
Inventory	28.7
Other current assets	24.0
Total current assets	$102.5
Total current liabilities	$201.2

Compute working capital and the current ratio.

Calculate liquidity and solvency ratios.

BE2.6 (LO 2), AP Ross Music Inc. reported the following selected information at March 31.

	2025
Total current assets	$262,787
Total assets	439,832
Total current liabilities	293,625
Total liabilities	376,002

Calculate (a) the current ratio and (b) the debt to assets ratio for March 31, 2025.

Recognize generally accepted accounting principles.

BE2.7 (LO 3), K Indicate whether each statement is true or false. If false, indicate how to correct the statement.

GAAP is a set of rules and practices established by accounting standard-setting bodies to serve as a general guide for financial reporting purposes.
The primary standard-setting body in the United States is the IRS.

Identify characteristics of useful information.

BE2.8 (LO 3), K The accompanying chart shows the qualitative characteristics of useful accounting information. Fill in the blanks.

A flowchart shows a list of qualitative characteristics useful to tabulate accounting information. A central box labeled as "Usefulness" has arrows extended on both the right and left sides. The left arrow points towards a box titled Fundamental qualities. An arrow points down from this box to a box listing relevance on the first line with three lines labeled as a, b, and c just below it. It is followed by another downward arrow to a box with four lines with the first labeled as Faithful representation, the third labeled as Neutral, and the second and fourth labeled as d and e, respectively. The right arrow points towards a box titled enhancing qualities with an arrow pointing down to four lines labeled as f, g, h, and Understandability. The alphabetical values in the boxes represent a blank.

Identify characteristics of useful information.

BE2.9 (LO 3), K Given the characteristics of useful accounting information, complete each of the following statements.

For information to be _____, it should have predictive and confirmatory value.
_____ means that information accurately depicts what really happened.
_____ means using the same accounting principles and methods from year to year within a company.

Identify characteristics of useful information.

BE2.10 (LO 3), K Here are some qualitative characteristics of useful accounting information:

Predictive value
Neutral
Verifiable
Timely

Match each qualitative characteristic to one of the following statements.

______ a. Accounting information should help provide accurate expectations about future events.
______ b. Accounting information cannot be selected, prepared, or presented to favor one set of interested users over another.
______ c. Independent observers, using the same methods, are able to obtain similar results.
______ d. Accounting information must be available to decision-makers before it loses its capacity to influence their decisions.

Define full disclosure principle.

BE2.11 (LO 3), K The full disclosure principle dictates that:

financial statements should disclose all assets at their cost.
financial statements should disclose only those events that can be measured in dollars.
financial statements should disclose sufficient detail regarding events and circumstances that would make a difference to users of financial statements.
financial statements should not be relied on unless an auditor has expressed an unqualified opinion on them.

DO IT! Exercises

Prepare assets section of balance sheet.

DO IT! 2.1a (LO 1), AP Mylar Corporation has collected the following information related to its December 31, 2025, balance sheet.

Accounts receivable	$22,000	Equipment	$180,000
Accumulated depreciation—equipment	50,000	Inventory	58,000
Cash	13,000	Supplies	7,000
Stock investments (long-term)	1,900	Goodwill	4,100

Prepare the assets section of Mylar Corporation’s balance sheet.

Classify financial statement items by balance sheet classification.

DO IT! 2.1b (LO 1), AP The following financial statement items were taken from the financial statements of Gomez Corp.

____Trademarks	____Inventory
____Notes payable (current)	____Accumulated depreciation
____Interest revenue	____Land
____Income taxes payable	____Common stock
____Debt investments (long-term)	____Advertising expense
____Unearned sales revenue	____Mortgage payable (due in 3 years)

Match each of the financial statement items to its proper balance sheet classification. (See E2.1 for a list of the balance sheet classifications.) If the item would not appear on a balance sheet, use “NA.”

Compute ratios and analyze.

DO IT! 2.2 (LO 2), AP The following information is available for Nguoi Corporation.

	2025	2024
Current assets	$ 54,000	$ 36,000
Total assets	240,000	205,000
Current liabilities	22,000	30,000
Total liabilities	72,000	100,000
Net income	80,000	40,000
Preferred dividends	6,000	6,000
Common dividends	3,000	1,500
Common shares outstanding at beginning of year	40,000	30,000
Common shares outstanding at end of year	75,000	40,000

Compute earnings per share for 2025 and 2024 for Nguoi, and comment on the change. Nguoi’s primary competitor, Matisse Corporation, had earnings per share of $1 per share in 2025. Comment on the difference in the ratios of the two companies.
Compute the current ratio and debt to assets ratio for each year, and comment on the changes.

Identify financial accounting concepts and principles.

DO IT! 2.3 (LO 3), K The following characteristics, assumptions, principles, and constraint guide the FASB when it creates accounting standards.

Relevance	Periodicity assumption
Faithful representation	Going concern assumption
Comparability	Historical cost principle
Consistency	Full disclosure principle
Monetary unit assumption	Materiality
Economic entity assumption	Cost constraint

Match each item above with a description below.

____Items not easily quantified in dollar terms are not reported in the financial statements.
____Accounting information must be complete, neutral, and free from material error.
____Personal transactions are not mixed with the company’s transactions.
____The cost to provide information should be weighed against the benefit that users will gain from having the information available.
____A company’s use of the same accounting principles from year to year.
____Assets are recorded and reported at original purchase price.
____Accounting information should help users predict future events, and should confirm or correct prior expectations.
____The life of a business can be divided into artificial segments of time.
____The reporting of sufficient details regarding circumstances and events that would make a difference to financial statement users.
____The judgment concerning whether omitting or misstating an item could influence the decision of a financial statement user.
____Assumes a business will remain in operation for the foreseeable future.
____Different companies use the same accounting principles.

Exercises

Classify accounts on balance sheet.

E2.1 (LO 1), AP The following are the major balance sheet classifications.

Current assets (CA)	Current liabilities (CL)
Long-term investments (LTI)	Long-term liabilities (LTL)
Property, plant, and equipment (PPE)	Stockholders’ equity (SE)
Intangible assets (IA)

Instructions

Classify each of the following financial statement items taken from Ming Corporation’s balance sheet.

____ Accounts payable	____ Income taxes payable
____ Accounts receivable	____ Inventory
____ Accumulated depreciation—equipment	____ Stock investments (to be sold in 7 months)
____ Accumulated depreciation—equipment	____ Land
____ Buildings	____ Mortgage payable
____ Cash	____ Supplies
____ Interest payable	____ Equipment
____ Goodwill	____ Prepaid rent

Classify financial statement items by balance sheet classification.

E2.2 (LO 1), AP The major balance sheet classifications are listed in E2.1.

Instructions

Classify each of the following financial statement items based upon the major balance sheet classifications listed in E2.1.

____ Prepaid advertising	____ Patents
____ Equipment	____ Bonds payable
____ Trademarks	____ Common stock
____ Salaries and wages payable	____ Accumulated depreciation—equipment
____ Income taxes payable	____ Accumulated depreciation—equipment
____ Retained earnings	____ Unearned sales revenue
____ Accounts receivable	____ Inventory
____ Land (held for future use)

Classify items as current or noncurrent, and prepare assets section of balance sheet.

E2.3 (LO 1), AP Suppose the following items were taken from the December 31, 2025, assets section of the Boeing Company balance sheet. (All dollars are in millions.)

Inventory	$16,933	Patents	$12,528
Notes receivable—due after December 31, 2026	5,466	Buildings	21,579
Notes receivable—due after December 31, 2026	5,466	Cash	9,215
Notes receivable—due before December 31, 2026	368	Accounts receivable	5,785
Notes receivable—due before December 31, 2026	368	Debt investments (short-term)	2,008
Accumulated depreciation—buildings	12,795

Instructions

Prepare the assets section of a classified balance sheet, listing the current assets in order of their liquidity.

Prepare assets section of a classified balance sheet.

An icon shows an encircled rightward pointing arrow with a text beside reads, Excel.

E2.4 (LO 1), AP Suppose the following information (in thousands of dollars) is available for H. J. Heinz Company—famous for ketchup and other fine food products—at April 30, 2025.

Prepaid insurance	$ 125,765	Buildings	$4,033,369
Land	76,193	Cash	373,145
Goodwill	3,982,954	Accounts receivable	1,171,797
Trademarks	757,907	Accumulated depreciation—buildings	2,131,260
Inventory	1,237,613

Instructions

Prepare the assets section of a classified balance sheet, listing the items in proper sequence and including a statement heading.

Prepare a classified balance sheet.

E2.5 (LO 1), AP These items are taken from the financial statements of Longhorn Co. at December 31, 2025.

Buildings	$105,800
Accounts receivable	12,600
Prepaid insurance	3,200
Cash	11,840
Equipment	82,400
Land	61,200
Insurance expense	780
Depreciation expense	5,300
Interest expense	2,600
Common stock	60,000
Retained earnings (January 1, 2025)	40,000
Accumulated depreciation—buildings	45,600
Accounts payable	9,500
Notes payable	93,600
Accumulated depreciation—equipment	18,720
Interest payable	3,600
Service revenue	14,700

Instructions

Prepare a classified balance sheet. Assume that $13,600 of the note payable will be paid in 2026.

Prepare a classified balance sheet.

E2.6 (LO 1), AP The following items are taken from the financial statements of Carmen Co. at December 31, 2025.

Land	$195,600
Accounts receivable	21,700
Supplies	9,200
Cash	11,840
Equipment	82,400
Buildings	261,200
Land improvements	45,780
Notes receivable (due in 2026)	5,300
Accumulated depreciation—land improvements	12,600
Common stock	75,000
Retained earnings (December 31, 2025)	495,000
Accumulated depreciation—buildings	32,600
Accounts payable	9,500
Mortgage payable	93,600
Accumulated depreciation—equipment	18,720
Interest payable	3,600
Income taxes payable	14,700
Patents	46,700
Investments in stock (long-term)	71,500
Debt investments (short-term)	4,100

Instructions

Prepare a classified balance sheet. Assume that $9,100 of the mortgage payable will be paid in 2026.

Prepare a classified balance sheet.

E2.7 (LO 1), AP Suppose the following items were taken from the 2025 financial statements of Texas Instruments, Inc. (All dollars are in millions.)

Common stock	$2,826	Accumulated depreciation—equipment	$3,547
Prepaid rent	164	Accounts payable	1,459
Equipment	6,705	Patents	2,210
Stock investments (long-term)	637	Notes payable (long-term)	810
Debt investments (short-term)	1,743	Retained earnings	6,896
Income taxes payable	128	Accounts receivable	1,823
Cash	1,182	Inventory	1,202

Instructions

Prepare a classified balance sheet in good form as of December 31, 2025.

Prepare liabilities and stockholders’ equity sections.

E2.8 (LO 1), AP Randal Inc.’s balance sheet, dated October 28, 2025, includes the following liabilities and stockholders’ equity items (in millions).

Accounts payable	$431.6	Long-term debt	$1,209.8
Common stock	642.4	Other long-term liabilities	122.6
Current portion of long-term debt	254.9	Retained earnings	979.8
Income taxes payable	14.8	Unearned sales revenue	16.0

Instructions

Prepare the liabilities and stockholders’ equity sections of the balance sheet.

Prepare a balance sheet.

E2.9 (LO 1), AP The financial statements of Summit Ltd. includes the following items at December 31, 2025.

Accounts payable	$ 21,050	Income tax expense	$ 5,200
Accounts receivable	20,780	Interest expense	4,550
Accumulated depreciation—buildings	50,600	Interest payable	2,100
Accumulated depreciation—buildings	50,600	Land	194,000
Accumulated depreciation—equipment	21,470	Long-term investments	28,970
Accumulated depreciation—equipment	21,470	Mortgage payable	104,000
Buildings	133,800	Operating expenses	158,680
Cash	24,040	Prepaid insurance	1,420
Common stock	140,000	Retained earnings, January 1	116,520
Equipment	66,100	Service revenue	183,040
		Supplies	1,240

Instructions

Calculate net income and the ending balance of retained earnings at December 31, 2025. It is not necessary to prepare a formal income statement or retained earnings statement.
Prepare a balance sheet dated December 31, 2025. Assume that the company will pay $30,500 of the mortgage payable in 2026.

Prepare financial statements.

E2.10 (LO 1), AP The following financial statement items are for Batra Corporation at year-end, July 31, 2025.

Operating expenses	$ 32,500	Interest payable	$ 1,000
Salaries and wages expense	44,700	Supplies expense	900
Unearned sales revenue	12,000	Dividends declared	12,000
Utilities expense	2,600	Depreciation expense	3,000
Equipment	62,900	Retained earnings, August 1, 2024	17,940
Accounts payable	4,220	Rent expense	10,800
Service revenue	113,600	Income tax expense	5,000
Rent revenue	18,500	Supplies	1,500
Common stock	25,000	Debt investments (short-term)	20,000
Cash	5,060	Bank loan payable (due December 31, 2025)	21,800
Accounts receivable	17,100	Bank loan payable (due December 31, 2025)	21,800
Accumulated depreciation—equipment	6,000	Interest expense	2,000
Accumulated depreciation—equipment	6,000

Instructions

Prepare an income statement, retained earnings statement, and balance sheet for the year.

Compute and interpret profitability ratio.

E2.11 (LO 2), AP Suppose the following information is available for Callaway Golf Company for the years 2025 and 2024. (Dollars are in thousands, except share information.)

	2025	2024
Net sales	$ 1,117,204	$ 1,124,591
Net income (loss)	66,176	54,587
Total assets	855,338	838,078
Share information
Common shares outstanding at year-end	64,507,000	66,282,000
Preferred dividends	–0–	–0–

There were 73,139,000 shares of common stock outstanding at the end of 2023.

Instructions

What was the company’s earnings per share for each year?
Based on your findings above, how did the company’s profitability change from 2024 to 2025?
Suppose the company had paid dividends on preferred stock and on common stock during the year. How would this affect your calculation in part (a)?

Prepare financial statements.

E2.12 (LO 1, 2), AP These financial statement items are for Fairview Corporation at year-end, July 31, 2025.

Salaries and wages payable	$ 2,080
Salaries and wages expense	57,500
Supplies expense	15,600
Equipment	18,500
Accounts payable	4,100
Service revenue	66,100
Rent revenue	8,500
Notes payable (due in 2028)	1,800
Common stock	16,000
Cash	29,200
Accounts receivable	9,780
Accumulated depreciation—equipment	6,000
Dividends	4,000
Depreciation expense	4,000
Retained earnings (beginning of the year)	34,000

Instructions

Prepare an income statement and a retained earnings statement for the year. Fairview Corporation did not issue any new stock during the year.
Prepare a classified balance sheet at July 31.
Compute the current ratio and debt to assets ratio.
Suppose that you are the president of Lunar Equipment. Your sales manager has approached you with a proposal to sell $20,000 of equipment to Fairview. He would like to provide a loan to Fairview in the form of a 10%, 5-year note payable. Evaluate how this loan would change Fairview’s current ratio and debt to assets ratio, and discuss whether you would make the sale.

Compute liquidity ratios and compare results.

E2.13 (LO 2), AP Nordstrom, Inc. operates department stores in numerous states. Selected financial statement data (in millions of dollars) for a recent year follow.

	Beginning of Year	End of Year
Cash and cash equivalents	$358	$72
Receivables (net)	1,788	1,942
Merchandise inventory	956	900
Other current assets	259	303
Total current assets	$3,361	$3,217
Total current liabilities	$1,635	$1,601

Instructions

Compute working capital and the current ratio at the beginning of the year and at the end of the year.
Did Nordstrom’s liquidity improve or worsen during the year?
Using the data in the chapter, compare Nordstrom’s liquidity with Best Buy’s.

Compute liquidity measures and discuss findings.

E2.14 (LO 2), AP The chief financial officer (CFO) of Myeneke Corporation requested that the accounting department prepare a preliminary balance sheet on December 30, 2025, so that the CFO could get an idea of how the company stood. He knows that certain debt agreements with its creditors require the company to maintain a current ratio of at least 2:1. The preliminary balance sheet is as follows.

Myeneke Corp. Balance Sheet December 30, 2025
Current assets			Current liabilities
Cash	$25,000		Accounts payable	$ 20,000
Accounts receivable	30,000		Salaries and wages payable	10,000	$ 30,000
Prepaid insurance	5,000	$ 60,000	Long-term liabilities
Equipment (net)		200,000	Notes payable		80,000
Total assets		$260,000	Total liabilities		110,000
			Stockholders’ equity
			Common stock	100,000
			Retained earnings	50,000	150,000
			Total liabilities and stockholders’ equity		$260,000

Instructions

Calculate the current ratio and working capital based on the preliminary balance sheet.
Based on the results in (a), the CFO requested that $20,000 of cash be used to pay off the balance of the Accounts Payable account on December 31, 2025. Calculate the new current ratio and working capital after the company takes these actions.
Discuss the pros and cons of the current ratio and working capital as measures of liquidity.
Was it unethical for the CFO to take these steps?

Compute and interpret solvency ratios.

E2.15 (LO 2), AP Suppose the following data were taken from the 2025 and 2024 financial statements of American Eagle Outfitters. (All numbers, including share data, are in thousands.)

	2025	2024
Current assets	$ 925,359	$1,020,834
Total assets	1,963,676	1,867,680
Current liabilities	401,763	376,178
Total liabilities	554,645	527,216
Net income	179,061	400,019
Dividends paid on common stock	82,394	80,796
Weighted-average common shares outstanding	205,169	216,119

Instructions

Perform each of the following.

Calculate the current ratio for each year.
Calculate earnings per share for each year.
Calculate the debt to assets ratio for each year.
Discuss American Eagle’s solvency in 2025 versus 2024.

Identify qualitative characteristics.

E2.16 (LO 3), K Here are some fundamental and enhancing qualitative characteristics of financial information.

Comparability
Completeness
Confirmatory value
Faithful representatio
Free from material error
Materiality
Neutrality
Predictive value
Relevance
Timeliness
Understandability
Verifiability

Instructions

Match each of the above characteristics to one of the following statements, using the numbers 1 to 12.

_____ Accounting information cannot be selected, prepared, or presented to favor one set of interested users over another.
_____ Accounting information must be available to decision-makers before it loses its ability to influence their decisions.
_____ Accounting information is prepared on the assumption that users have a reasonable understanding of accounting and general business and economic conditions.
_____ Accounting information provides a basis to evaluate a previously made decision.
_____ Accounting information includes everything that it needs to; nothing important is omitted. This is an important component of faithful representation.
_____ Accounting information helps users make predictions about the outcome of past, present, and future events.
_____ Accounting information about one company can be evaluated against the accounting information from another company.
_____ Accounting information is included if its omission or misstatement could influence the decisions of financial statement users. This is an important component of relevance.
_____ All the accounting information that is necessary to faithfully represent economic reality is included.
_____ Accounting information has few inaccuracies.
_____ Accounting information that will make a difference in users’ decisions.
_____ Accounting information about a company can be confirmed by two or more independent users to be a faithful representation.

Identify accounting assumptions and principles.

E2.17 (LO 3), K Presented below are the assumptions and principles discussed in this chapter.

Full disclosure principle
Going concern assumption
Monetary unit assumption
Periodicity assumption
Historical cost principle
Economic entity assumption

Instructions

Identify by number the accounting assumption or principle that is described below. Do not use a number more than once.

_____ a. Belief that a company will remain in business for the foreseeable future. (Note: Do not use the historical cost principle.)
_____ b. Indicates that personal and business recordkeeping should be separately maintained.
_____ c. Only those things that can be expressed in money are included in the accounting records.
_____ d. Separates financial information into time periods for reporting purposes.
_____ e. Measurement basis used when a reliable estimate of fair value is not available.
_____ f. Dictates that companies should disclose sufficient details regarding circumstances and events that would make a difference to financial statement users.

Identify accounting terminology.

E2.18 (LO 1, 2, 3), K The following list of terms or phrases are discussed in this chapter.

Securities and Exchange Commission (SEC)
Solvency
Financial Accounting Standards Board (FASB)
Materiality
Cost constraint
Faithful representation
Liquidity
Working capital
Operating cycle
Generally accepted accounting principles (GAAP)
Current liabilities
Relevance
Verifiable

Instructions

Match each term or phrase to its description below.

_____ Whether omitting or misstating an item could influence the decision of a financial statement user.
_____ Constraint that weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.
_____ Obligations that a company expects to pay within the next year or operating cycle, whichever is longer.
_____ Information that is complete, neutral, and free from material error.
_____ The primary accounting standard-setting body in the United States.
_____ A set of accounting standards that has substantial authoritative support and which guide accounting professionals.
_____ The ability of a company to pay obligations that are expected to become due within the next year or operating cycle.
_____ The average time required to purchase inventory, sell it on account, and then collect cash from customers—that is, go from cash to cash.
_____ The information has predictive value as well as confirms or corrects prior expectations.
_____ The agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies.
_____ The quality of information that occurs when independent observers, using the same methods, obtain similar results.
_____ The difference between the amounts of current assets and current liabilities.
_____ The ability of a company to pay interest as it comes due and to repay the balance of a debt due at its maturity.

Identify the assumption or principle that has been violated.

E2.19 (LO 3), C Lopez Co. had three major business transactions during 2025.

Reported at its fair value of $260,000 merchandise inventory with a cost of $208,000.
The president of Lopez Co., Victor Lopez, purchased a truck for personal use and charged it to his expense account.
Lopez Co. wanted to make its 2025 income look better, so it added 2 more weeks to its income statement reporting period (a 54-week year). Previous years were 52 weeks.

Instructions

In each situation, identify the assumption or principle that has been violated, if any, and discuss what the company should have done.

Problems

Prepare a classified balance sheet.

P2.1 (LO 1), AP Suppose the following items are taken from the 2025 balance sheet of Verizon Communications. (All dollars are in millions.)

Goodwill	$3,927
Common stock	6,283
Equipment	1,737
Accounts payable	152
Patents	234
Stock investments (long-term)	3,247
Accounts receivable	1,061
Prepaid rent	233
Debt investments (short-term)	1,160
Retained earnings	6,108
Cash	2,292
Notes payable (long-term)	734
Unearned sales revenue	413
Accumulated depreciation—equipment	201

Instructions

Prepare a classified balance sheet for Verizon Communications as of December 31, 2025.

Tot. current assets	$4,746
Tot. assets	$13,690

Prepare financial statements.

P2.2 (LO 1), AP These items are taken from the financial statements of Martin Corporation for 2025.

Retained earnings (beginning of year)	$31,000
Utilities expense	2,000
Equipment	66,000
Accounts payable	18,300
Cash	10,100
Salaries and wages payable	3,000
Common stock	22,800
Dividends	12,000
Supplies	3,100
Debt investment (long-term)	5,700
Trademarks	2,000
Service revenue	68,000
Prepaid insurance	3,500
Maintenance and repairs expense	1,800
Depreciation expense	3,600
Accounts receivable	11,700
Insurance expense	2,200
Salaries and wages expense	37,000
Accumulated depreciation—equipment	17,600

Instructions

Prepare an income statement, a retained earnings statement, and a classified balance sheet as of December 31, 2025.

Net income	$21,400
Tot. assets	$84,500

Prepare financial statements.

P2.3 (LO 1), AP You are provided with the following information for Lazuris Enterprises, effective as of its April 30, 2025, year-end.

Accounts payable	$834
Accounts receivable	810
Accumulated depreciation—equipment	670
Cash	1,270
Common stock	16,900
Cost of goods sold	1,060
Depreciation expense	335
Dividends	325
Equipment	2,420
Goodwill	1,800
Income tax expense	165
Income taxes payable	135
Insurance expense	210
Interest expense	400
Inventory	967
Investment in land	14,200
Land	3,100
Mortgage payable (long-term)	3,500
Notes payable (short-term)	61
Prepaid insurance	60
Retained earnings (beginning)	1,600
Salaries and wages expense	700
Salaries and wages payable	222
Sales revenue	5,100
Stock investments (short-term)	1,200

Instructions

Prepare an income statement and a retained earnings statement for Lazuris Enterprises for the year ended April 30, 2025.
Prepare a classified balance sheet for Lazuris Enterprises as of April 30, 2025.

a.	Net income	$2,230
b.	Tot. current assets	$4,307
	Tot. assets	$25,157

Compute ratios; comment on relative profitability, liquidity, and solvency.

P2.4 (LO 2), AN Writing Comparative financial statement data for Loeb Corporation and Bowsh Corporation, two competitors, appear below. All balance sheet data are as of December 31, 2025.

	Loeb Corporation	Bowsh Corporation
Net sales	$1,800,000	$620,000
Cost of goods sold	1,175,000	340,000
Operating expenses	283,000	98,000
Interest expense	9,000	3,800
Income tax expense	85,000	36,000
Current assets	407,200	190,336
Plant assets (net)	532,000	139,728
Current liabilities	66,325	33,716
Long-term liabilities	108,500	40,684
Dividends paid on common stock	36,000	15,000
Weighted-average common shares outstanding	80,000	50,000

Instructions

Comment on the relative profitability of the companies by computing the net income and earnings per share for each company for 2025.
Comment on the relative liquidity of the companies by computing working capital and the current ratio for each company for 2025.
Comment on the relative solvency of the companies by computing the debt to assets ratio for each company for 2025.

Compute and interpret liquidity, solvency, and profitability ratios.

P2.5 (LO 2), AP Writing The following are financial statements of Ohara Company.

Ohara Company Income Statement For the Year Ended December 31, 2025
Net sales	$2,218,500
Cost of goods sold	1,012,400
Selling and administrative expenses	906,000
Interest expense	78,000
Income tax expense	69,000
Net income	$153,100

Ohara Company Balance Sheet December 31, 2025
Assets
Current assets
Cash	$60,100
Debt investments	84,000
Accounts receivable (net)	169,800
Inventory	145,000
Total current assets	458,900
Plant assets (net)	575,300
Total assets	$1,034,200
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable	$ 160,000
Income taxes payable	35,500
Total current liabilities	195,500
Bonds payable	200,000
Total liabilities	395,500
Stockholders’ equity
Common stock	350,000
Retained earnings	288,700
Total stockholders’ equity	638,700
Total liabilities and stockholders’ equity	$1,034,200

Additional information: The weighted-average common shares outstanding during the year was 50,000.

Instructions

Compute the following values and ratios for 2025. (We provide the results from 2024 for comparative purposes.)
1. Working capital. (2024: $160,500)
2. Current ratio. (2024: 1.65:1)
3. Debt to assets ratio. (2024: 31%)
4. Earnings per share. (2024: $3.15)
Using your calculations from part (a), discuss changes from 2024 in liquidity, solvency, and profitability.

Compute and interpret liquidity, solvency, and profitability ratios.

P2.6 (LO 2), AP Writing Condensed balance sheet and income statement data for Danke Corporation are presented as follows.

Danke Corporation Balance Sheets December 31
	2025	2024
Assets
Cash	$28,000	$20,000
Receivables (net)	70,000	62,000
Other current assets	90,000	73,000
Long-term investments	62,000	60,000
Property, plant, and equipment (net)	510,000	470,000
Total assets	$760,000	$685,000
Liabilities and Stockholders’ Equity
Current liabilities	$75,000	$70,000
Long-term liabilities	80,000	90,000
Common stock	330,000	300,000
Retained earnings	275,000	225,000
Total liabilities and stockholders’ equity	$760,000	$685,000

Danke Corporation Income Statements For the Years Ended December 31
	2025	2024
Sales revenue	$750,000	$680,000
Cost of goods sold	440,000	400,000
Operating expenses (including income taxes)	240,000	220,000
Net income	$ 70,000	$ 60,000

Additional information:

Dividends paid	$20,000	$15,000
Weighted-average common shares outstanding	33,000	30,000

Instructions

Compute these values and ratios for 2024 and 2025.

Earnings per share.
Working capital.
Current ratio.
Debt to assets ratio.
Based on the ratios calculated, discuss briefly the improvement or lack thereof in financial position and operating results from 2024 to 2025 of Danke Corporation.

Compute ratios and compare liquidity and solvency for two companies.

P2.7 (LO 2), AP Selected financial data of two competitors, Target and Walmart, are presented here. (All dollars are in millions.) Suppose the data were taken from the 2025 financial statements of each company.

	Target (1/31/25)	Walmart (1/31/25)
	Income Statement Data for Year
Net sales	$64,948	$401,244
Cost of goods sold	44,157	306,158
Selling and administrative expenses	16,389	76,651
Interest expense	894	2,103
Other income	28	4,213
Income taxes	1,322	7,145
Net income	$ 2,214	$ 13,400
	Balance Sheet Data (End of Year)
Current assets	$17,488	$ 48,949
Noncurrent assets	26,618	114,480
Total assets	$44,106	$163,429
Current liabilities	$10,512	$ 55,390
Long-term liabilities	19,882	42,754
Total stockholders’ equity	13,712	65,285
Total liabilities and stockholders’ equity	$44,106	$163,429
Weighted-average common shares outstanding (millions)	774	3,951

Instructions

For each company, compute these values and ratios.

Working capital.
Current ratio.
Debt to assets ratio.
Earnings per share.
Compare the liquidity and solvency of the two companies.

Comment on the objectives and qualitative characteristics of financial reporting.

P2.8 (LO 3), E Writing A friend of yours, Saira Ortiz, recently completed an undergraduate degree in science and has just started working with a biotechnology company. Saira tells you that the owners of the business are trying to secure new sources of financing which are needed in order for the company to proceed with development of a new healthcare product. Saira said that her boss told her that the company must put together a report to present to potential investors.

Saira thought that the company should include in this package the detailed scientific findings related to the Phase I clinical trials for this product. She said, “I know that the biotech industry sometimes has only a 10% success rate with new products, but if we report all the scientific findings, everyone will see what a sure success this is going to be! The president was talking about the importance of following some set of accounting principles. Why do we need to look at some accounting rules? What they need to realize is that we have scientific results that are quite encouraging, some of the most talented employees around, and the start of some really great customer relationships. We haven’t made any sales yet, but we will. We just need the funds to get through all the clinical testing and get government approval for our product. Then these investors will be quite happy that they bought in to our company early!”

Instructions

What is accounting information? Explain to Saira what is meant by generally accepted accounting principles.
Comment on how Saira’s suggestions for what should be reported to prospective investors conforms to the qualitative characteristics of accounting information. Do you think that the things that Saira wants to include in the information for investors will conform to financial reporting guidelines?

Continuing Case

Cookie Creations

(Note: This is a continuation of the Cookie Creations from Chapter 1.)

CCC2 After investigating the different forms of business organization, Natalie Koebel decides to operate her business as a corporation, Cookie Creations Inc., and she begins the process of getting her business running.

While at a trade show, Natalie is introduced to Gerry Richards, operations manager of “Biscuits,” a national food retailer. After much discussion, Gerry asks Natalie to consider being Biscuits’ major supplier of oatmeal chocolate chip cookies. He provides Natalie with the most recent copy of the financial statements of Biscuits. He expects that Natalie will need to supply Biscuits’ Watertown warehouse with approximately 1,500 dozen cookies a week. Natalie is to send Biscuits a monthly invoice, and she will be paid approximately 30 days from the date the invoice is received in Biscuits’ Chicago office.

Natalie is thrilled with the offer. However, she has recently read in the newspaper that Biscuits has a reputation for selling cookies and donuts with high amounts of sugar and fat, and as a result, consumer demand for the company’s products has decreased.

Instructions

Natalie has several questions. Answer the following questions for Natalie.

What type of information does each financial statement provide?
What financial statements would Natalie need in order to evaluate whether Biscuits will have enough cash to meet its current liabilities? Explain what to look for.
What financial statements would Natalie need in order to evaluate whether Biscuits will be able to survive over a long period of time? Explain what to look for.
What financial statements would Natalie need in order to evaluate Biscuits’ profitability? Explain what to look for.
Where can Natalie find out whether Biscuits has outstanding debt? How can Natalie determine whether Biscuits would be able to meet its interest and debt payments on any debt it has?
How could Natalie determine whether Biscuits pays a dividend?
In deciding whether to go ahead with this opportunity, are there other areas of concern that Natalie should be aware of?

Expand Your Critical Thinking

Financial Reporting Problem: Apple Inc.

CT2.1 The financial statements of Apple Inc. are presented in Appendix A.

Instructions

Answer the following questions using the financial statements and the notes to the financial statements.

What were Apple’s total current assets at September 26, 2020, and September 28, 2019?
Are the assets included in current assets listed in the proper order? Explain.
How are Apple’s assets classified?
What were Apple’s current liabilities at September 26, 2020, and September 28, 2019?

Comparative Analysis Problem: Columbia Sportswear Company vs. Under Armour, Inc.

CT2.2 The financial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of Under Armour, Inc. are presented in Appendix C. Assume Columbia’s weighted-average common shares outstanding was 69,683,000, and Under Armour’s was 416,103,000.

Instructions

For each company, calculate the following values for 2020.
1. Working capital.
2. Current ratio.
3. Debt to assets ratio.
Based on your findings above, discuss the relative liquidity and solvency of the two companies.

Comparative Analysis Problem: Amazon.com, Inc. vs. Walmart Inc.

CT2.3 Amazon.com, Inc.’s financial statements are presented in Appendix D. Financial statements of Walmart Inc. are presented in Appendix E.

Instructions

For each company, calculate the following values for the most recent year provided.
1. Working capital.
2. Current ratio.
3. Debt to assets ratio.
Based on your findings above, discuss the relative liquidity and solvency of the two companies.

Interpreting Financial Statements

CT2.4 Suppose the following information was reported by Gap, Inc.

	2025	2024	2023	2022	2021
Total assets (millions)	$7,065	$7,985	$7,564	$7,838	$8,544
Working capital	$1,831	$2,533	$1,847	$1,653	$2,757
Current ratio	1.87:1	2.19:1	1.86:1	1.68:1	2.21:1
Debt to assets ratio	.42:1	.39:1	.42:1	.45:1	.39:1
Earnings per share	$1.89	$1.59	$1.35	$1.05	$0.94

Determine the overall percentage decrease in Gap’s total assets from 2021 to 2025. What was the average decrease per year? (Note: The period of time from December 31, 2021, to December 31, 2025, is four years. Therefore, you should divide by four years when computing the average.)
Comment on the change in Gap’s liquidity. Does working capital or the current ratio appear to provide a better indication of Gap’s liquidity? What might explain the change in Gap’s liquidity during this period?
Comment on the change in Gap’s solvency during this period.
Comment on the change in Gap’s profitability during this period. How might this affect your prediction about Gap’s future profitability?

Real-World Focus

CT2.5 You can use the Internet to identify summary liquidity, solvency, and profitability information about companies, and compare this information across companies in the same industry.

Instructions

Select a well-known company and then go to the Yahoo! Finance website to locate information to answer the following questions.

What is the company’s name? What was the company’s current ratio and debt to equity ratio (a variation of the debt to assets ratio)?
What is the company’s industry?
What is the name of a competitor? What is the competitor’s current ratio and its debt to equity ratio?
Based on these measures, which company is more liquid? Which company is more solvent?

CT2.6 The Feature Story described the dramatic effect that investor bulletin boards are having on the investment world. This exercise will allow you to evaluate a bulletin board discussing a company of your choice.

Instructions

Go to the Yahoo! Finance website. Type in a company name (or use the index to find it) and then use the Conversations tab to answer the following questions.

State the nature of each of these messages (e.g., offering advice, criticizing company, predicting future results, ridiculing other people who have posted messages).
For those messages that expressed an opinion about the company, was evidence provided to support the opinion?
What effect do you think it would have on bulletin board discussions if the participants provided their actual names? Do you think this would be a good policy?

Decision-Making Across the Organization

CT2.7 As a financial analyst in the planning department for Erin Industries, Inc., you must develop ratios from the comparative financial statements. This information is to be used to convince creditors that, despite a slight decline in sales, Erin Industries, Inc. is liquid, solvent, and profitable, and that it deserves their continued support. Lenders are particularly concerned about the company’s ability to continue as a going concern.

Here are the data requested and the computations developed from the financial statements:

	2025	2024
Current ratio	3.1	2.1
Working capital	Up 22%	Down 7%
Debt to assets ratio	0.60	0.70
Net income	Up 32%	Down 8%
Earnings per share	$2.40	$1.15

Instructions

Erin Industries, Inc. asks you to prepare brief comments stating how each of these items supports the argument that its financial health is improving. The company wishes to use these comments to support presentation of data to its creditors. With the class divided into groups, prepare the comments as requested, giving the implications and the limitations of each item regarding Erin’s financial well-being.

Communication Activity

CT2.8 B. P. Palmer is the chief executive officer of Future Products. Palmer is an expert engineer but a novice in accounting.

Instructions

Write a letter to B. P. Palmer that explains (a) the three main types of ratios; (b) examples of each, how they are calculated, and what they measure; and (c) the bases for comparison in analyzing Future Products’ financial statements.

Ethics Case

CT2.9 At one time, Boeing closed a giant deal to acquire another manufacturer, McDonnell Douglas. Boeing paid for the acquisition by issuing shares of its own stock to the stockholders of McDonnell Douglas. In order for the deal not to be revoked, the value of Boeing’s stock could not decline below a certain level for a number of months after the deal.

During the first half of the year, Boeing suffered significant cost overruns because of inefficiencies in its production methods. Had these problems been disclosed in the quarterly financial statements during the first and second quarters of the year, the company’s stock most likely would have plummeted, and the deal would have been revoked. Company managers spent considerable time debating when the bad news should be disclosed. One public relations manager suggested that the company’s problems be revealed on the date of either Princess Diana’s or Mother Teresa’s funeral, in the hope that it would be lost among those big stories that day. Instead, the company waited until October 22 of that year to announce a $2.6 billion write-off due to cost overruns. Within one week, the company’s stock price had fallen 20%, but by this time the McDonnell Douglas deal could not be reversed.

Instructions

Answer the following questions.

Who are the stakeholders in this situation?
What are the ethical issues?
What assumptions or principles of accounting are relevant to this case?
Do you think it is ethical to try to “time” the release of a story so as to diminish its effect?
What would you have done if you were the chief executive officer of Boeing?
Boeing’s top management maintains that it did not have an obligation to reveal its problems during the first half of the year. What implications does this have for investors and analysts who follow Boeing’s stock?

All About You

CT2.10 Every company needs to plan in order to move forward. Its top management must consider where it wants the company to be in three to five years. Like a company, you need to think about where you want to be three to five years from now, and you need to start taking steps now in order to get there.

Instructions

Provide responses to each of the following items.

Where would you like to be working in three to five years? Describe your plan for getting there by identifying between five and 10 specific steps that you need to take in order to get there.
In order to get the job you want, you will need a résumé. Your résumé is the equivalent of a company’s annual report. It needs to provide relevant information that is a faithful representation about your past accomplishments so that employers can decide whether to “invest” in you. Do a search on the Internet to find a good résumé format. What are the basic elements of a résumé?
A company’s annual report provides information about a company’s accomplishments. In order for investors to use the annual report, the information must provide a faithful representation. How can you assure that the information on your résumé provides a faithful representation about you and your accomplishments?
Prepare a résumé assuming that you have accomplished the five to 10 specific steps you identified in part (a). Also, provide evidence that would give assurance that the information is a faithful representation.

FASB Codification Activity

CT2.11 If your school has a subscription to the FASB Codification, log in and prepare responses to the following.

Instructions

Access the glossary (“Master Glossary”) at the FASB Codification website to answer the following.
1. What is the definition of current assets?
2. What is the definition of current liabilities?
A company wants to offset its accounts payable against its cash account and show a cash amount net of accounts payable on its balance sheet. Identify the criteria (found in the FASB Codification) under which a company has the right of set off. Does the company have the right to offset accounts payable against the cash account?

Considering People, Planet, and Profit

CT2.12 Auditors provide a type of certification of corporate financial statements. Certification is used in many other aspects of business as well. For example, it plays a critical role in the sustainability movement. An article by Angus Chen, entitled “Do Sustainable Certifications for Coffee Really Help the Coffee Growers,” discusses the role of certification in the coffee business.

Instructions

Search and read the article online, and then answer the following questions.

The article mentions different certification types that coffee growers can obtain from different certification bodies. Using financial reporting as an example, what potential problems might the existence of multiple certification types present to coffee purchasers?
What social and environmental benefits are coffee certifications trying to achieve? Are there also potential financial benefits to the parties involved?

A Look at IFRS

The classified balance sheet, although generally required internationally, contains certain variations in format when reporting under IFRS. The following are the key similarities and differences between GAAP and IFRS related to the financial statements.

Similarities

IFRS generally requires a classified statement of financial position similar to the classified balance sheet under GAAP.
IFRS follows the same guidelines as this text for distinguishing between current and noncurrent assets and liabilities.

Differences

IFRS recommends but does not require the use of the title “statement of financial position” rather than balance sheet.
The format of statement of financial position information is often presented differently under IFRS. Although no specific format is required, many companies that follow IFRS present statement of financial position information in this order:
- Non-current assets
- Current assets
- Equity
- Non-current liabilities
- Current liabilities
Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last.

IFRS has many differences in terminology from what are shown in your text. For example, in the following sample statement of financial position, notice in the investment category that stock is called shares.

Franklin Corporation Statement of Financial Position October 31, 2025
Assets
Intangible assets
Patents			$3,100
Property, plant, and equipment
Land		$10,000
Equipment	$24,000
Less: Accumulated depreciation	5,000	19,000	29,000
Long-term investments
Share investments		5,200
Investment in real estate		2,000	7,200
Current assets
Prepaid insurance		400
Supplies		2,100
Inventory		3,000
Notes receivable		1,000
Accounts receivable		7,000
Debt investments		2,000
Cash		6,600	22,100
Total assets			$61,400
Equity and Liabilities
Equity
Share capital		$20,050
Retained earnings		14,000	$34,050
Non-current liabilities
Mortgage payable		10,000
Notes payable		1,300	11,300
Current liabilities
Notes payable		11,000
Accounts payable		2,100
Salaries and wages payable		1,600
Unearned service revenue		900
Interest payable		450	16,050
Total equity and liabilities			$61,400

Both GAAP and IFRS are increasing the use of fair value to report assets. However, at this point IFRS has adopted it more broadly. As examples, under IFRS companies can apply fair value to property, plant, and equipment, and in some cases intangible assets.

IFRS Practice

IFRS Self-Test Questions

1. A company has purchased a tract of land and expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. Under IFRS, the land should be reported as:

land expense.
property, plant, and equipment.
an intangible asset.
a long-term investment.

2. Current assets under IFRS are listed generally:

by importance.
in the reverse order of their expected conversion to cash.
by longevity.
alphabetically.

3. Companies that use IFRS:

may report all their assets on the statement of financial position at fair value.
may offset assets against liabilities and show net assets and net liabilities on their statement of financial position, rather than the underlying detailed line items.
may report non-current assets before current assets on the statement of financial position.
do not have any guidelines as to what should be reported on the statement of financial position.

4. Companies that follow IFRS to prepare a statement of financial position generally use the following order of classification:

current assets, current liabilities, non-current assets, non-current liabilities, equity.
non-current assets, non-current liabilities, current assets, current liabilities, equity.
non-current assets, current assets, equity, non-current liabilities, current liabilities.
equity, non-current assets, current assets, non-current liabilities, current liabilities.

IFRS Exercises

IFRS2.1 In what ways does the format of a statement of financial of position under IFRS often differ from a balance sheet presented under GAAP?

IFRS2.2 What term is commonly used under IFRS in reference to the balance sheet?

IFRS2.3 The statement of financial position for Sundell Company includes the following accounts (in British pounds): Accounts Receivable £12,500, Prepaid Insurance £3,600, Cash £15,400, Supplies £5,200, and Debt Investments (short-term) £6,700. Prepare the current assets section of the statement of financial position, listing the accounts in proper sequence.

IFRS2.4 The following information is available for Lessila Bowling Alley at December 31, 2025.

Buildings	$128,800	Share Capital	$100,000
Accounts Receivable	14,520	Retained Earnings (beginning)	15,000
Prepaid Insurance	4,680	Accumulated Depreciation—Buildings	42,600
Cash	18,040	Accounts Payable	12,300
Equipment	62,400	Notes Payable	97,780
Land	64,000	Accumulated Depreciation—Equipment	18,720
Insurance Expense	780	Interest Payable	2,600
Depreciation Expense	7,360	Bowling Revenues	14,180
Interest Expense	2,600

Prepare a classified statement of financial position. Assume that $13,900 of the notes payable will be paid in 2023.

International Comparative Analysis Problem: Apple vs. Louis Vuitton

IFRS2.5 The complete annual report of Louis Vuitton, including the notes to its financial statements, is available at the company’s website.

Instructions

Identify five differences in the format of the statement of financial position used by Louis Vuitton compared to a company, such as Apple, that follows GAAP. (Apple’s financial statements are available in Appendix A.)

Answers to IFRS Self-Test Questions

1. d2. b3. c4. c

Best Buy Co., Inc. Income Statements For the Year Ended February 1, 2020, and the Year Ended February 2, 2019 (in millions)
		2020	2019
	Revenues
	Net sales and other revenue	$43,686	$42,940
	Expenses
	Cost of goods sold	33,590	32,918
	Selling, general, and administrative expenses and other	8,103	8,134
	Income tax expense	452	424
	Total expenses	42,145	41,476
	Net income (loss)	$1,541	$1,464

Best Buy Co., Inc. Balance Sheets (in millions)
		February 1, 2020	February 3, 2019
	Assets
	Current assets
	Cash and cash equivalents	$2,229	$1,980
	Receivables	1,149	1,015
	Merchandise inventories	5,174	5,409
	Other current assets	305	466
	Total current assets	8,857	8,870
	Property and equipment	9,228	9,200
	Less: Accumulated depreciation	6,900	6,690
	Net property and equipment	2,328	2,510
	Other assets	4,406	1,521
	Total assets	$15,591	$12,901
	Liabilities and Stockholders’ Equity
	Current liabilities
	Accounts payable	$ 5,288	$ 5,257
	Unredeemed gift card liabilities	281	290
	Accrued compensation payable	410	482
	Other current liabilities	2,081	1,484
	Total current liabilities	8,060	7,513
	Long-term liabilities
	Long-term debt	1,257	1,332
	Other long-term liabilities	2,795	750
	Total long-term liabilities	4,052	2,082
	Total liabilities	12,112	9,595
	Stockholders’ equity
	Common stock	26	27
	Retained earnings and other	3,453	3,279
	Total stockholders’ equity	3,479	3,306
	Total liabilities and stockholders’ equity	$15,591	$12,901

2025		2024
$\frac{($ 100, 000 - $ 10, 000)}{(120, 000 + 60, 000) \div 2} = $ 1.00$		$\frac{($ 50, 000 - $ 10, 000)}{(60, 000 + 40, 000) \div 2} = $ 0.80$

	2025	2024
Current ratio	$\frac{$88,000}{$40,000} = 2 .20:1$	$\frac{$60,800}{$38,000} = 1 .60:1$
Debt to assets ratio	$\frac{$120,000}{$400,000} = 30%$	$\frac{$150,000}{$341,000} = 44%$