Chapter 3 Notes

1.
The role of the Financial Accounting Standards

Board (FASB) and Public Company Accounting
Oversight Board (PCAOB) regulatory agencies in 3. The notes to the financial statements are
the financial reporting of businesses is highly important because they provide detailed
significant. The general accepted accounting information not directly available in the financial
standards that firms must comply with and the statements. The flotnotes provide information on
procedures in monitoring those standards are accounting policies. procedures, calculation, and
referred to as generally accepted accounting transactions underlying entries in the financial
procedures (GAAP) and are established primarily statements.
by the FASB. The PCAOB has as one of its 4. Financial Accounting Standards Board
primary duties serving as the watchdog over the Statement No. 52 describes the rules for
public accounting profession. Public accounting consolidating a company's foreign and domestic
firms have reports that must be submitted to the financial statements. It requires U.S.-based
PCAOB documenting compliance with auditing companies to translate foreign-currency-
standards established by the PCAOB. Both the denominated assets and liabilities into U.S. dollars
process of monitoring the accountants and the use using the current rate (translation) method. This
of GAAP in financial reporting are necessary to method uses the exchange rate prevailing on the
restore and maintain public confidence in the date the fiscal year ends (the current rate). Income
financial information distributed to the public. statement items can be translated using either the
current rate or an average exchange rate for the
period covered by the statement. Equity accounts
2. The purpose of each of the four major financial are converted at the exchange rate on the date of
statements are: the investment. In the retained earnings account
any gains and losses from currency fluctuations
Income Statement-The purpose of the income are stated separately in an equity reserve account-
statement is to provide a financial summary of the the cumulative translation adjustment account and
firm's operating results during a specified time not realized until the parent company sells or
period. It includes both the sales for the firm and closes the foreign operations
the costs incurred in generating those sales. Other
expenses, such as taxes, are also included on this 5. Current and prospective shareholders place
statement. primary emphasis on the firm's current and future
level of risk and return as measures of
Balance Sheet-The purpose of the balance sheet profitability, while creditors are more concerned
is to present a summary of the assets owned by the with short-term liquidity measures of debt.
firm, the liabilities owed by the firm, and the net Stockholders are, therefore, most interested in
financial position of the owners as of a given income statement measures. and creditors are
point in time. The assets are often referred to as most concerned with balance sheet measures.
investments and the liabilities and owner's equity Management is concerned with all ratio measures,
as financing since they recognize that stockholders and
creditors must see good ratios in order to keep the
Statement of Retained Earnings-This statement
stock price up and raise new funds.
reconciles the net income earned during the year,
and any cash dividends paid, with the change in 6. Cross-sectional comparisons are made by
retained earnings during the year. comparing similar ratios for firms within the same
industry or to an industry average as of some point
Statement of Cash Flows-This statement provides
in time. Time-series comparisons are made by
a summary of the cash inflows and the cash
comparing similar ratios for a firm measured at
outflows experienced by the firm during the
various points in time. Benchmarking is the term
period of concern. The inflows and outflows are
used to describe this cross-sectional comparison
grouped into the cash flow areas of operations,
with competitor firms.
investment, and financing.
13. The debt ratio and the debt-equity ratio may
be used to measure the firm's degree of
7. The analyst should devote primary attention to indebtedness. The times-interest-earned and the
any significant deviations from the norm, whether fixed-payment coverage ratios can be used to
above or below. Positive deviations from the norm assess the firm's ability to meet fixed payments
are not necessarily favorable. An above-normal associated with debt.
inventory turnover ratio may indicate highly
efficient inventory management but may also 14. Three ratios of profitability found on a
reveal excessively low inventory levels resulting common-size income statement are: (1) the gross
in stockouts. Further examination into the profit margin, (2) the operating profit margin,
deviation would be required. and (3) the net profit margin.
8. Comparing financial statements from different 15. Firms that have high gross profit margins and
points in the year can result in inaccurate and low net profit margins have high levels of
misleading analysis due to the effects of expenses other than cost of goods sold. In this
seasonality. Levels of current assets can fluctuate case, the high expenses more than compensate for
significantly, depending on a company's business, the low cost of goods sold (i.e.. high gross profit
so statements from the same month or year end margin) thereby resulting in a low net profit
should be used in the analysis to ensure valid margin.
comparisons of performance.
16. The owners are probably most interested in the
9. The current ratio proves to be the better return on equity (ROE) since it indicates the rate
liquidity measure when all of the firm's current of return they earn on their investment in the firm.
assets are reasonably liquid. The quick ratio ROE is calculated by taking earnings available to
would prove to be the superior measure if the common shareholder and dividing by
inventory of the firm is considered to lack the stockholders' equity.
ability to be easily converted into cash.
17. The price-earnings ratio (P/E) is the market
10. Large businesses typically have established price per share of common stock divided by the
relationships with banks that can provide access to earnings per share. It indicates the amount the
short- term funds in the event that the firm has a investor is willing to pay for each dollar of
need for liquidity. Whole Foods, the natural and earnings. It is used to assess the owner's appraisal
organic grocery store, needs to have more rapid of the value of the firm's earnings. The level of the
turnover than even the typical grocery store in P/E ratio indicates the degree of confidence that
order to keep fresh produce on the shelves. It investors have in the firm's future. The
offers a more focused food selection, reducing its market/book (M/B) ratio is the market price per
inventory and increasing its inventory turnover of common stock divided by the firm's book value
ratio. per share. Firms with high M/B ratios are
expected to perform better than firms with lower
11. Additional information is necessary to assess relative MB values.
how well a firm collects receivables and meets
payables. The average collection period of 18. Liquidity ratios measure how well the firm
receivables should be compared to a firm's own can meet its current (short-term) obligations when
credit terms. The average payment period should they come due.
be compared to the creditors' credit terms.
Activity ratios are used to measure the speed with
12. Financial leverage is the term used to which various accounts are converted (or could be
describe the magnification of risk and return converted) into cash or sales.
introduced through the use of fixed-cost
financing, such as debt and preferred stock. Debt ratios measure how much of the firm is
financed with other people's money and the firm's
ability to meet fixed charges.
Profitability ratios measure a firm's return with
respect to sales, assets, or equity.
Market ratios give insight into how well

investors in the marketplace feel the firm is doing
in terms of return and risk.
The liquidity and debt ratios are most important to

present any prospective creditors.
19. The analyst may approach a complete ratio

analysis on either a cross-sectional or time-series
basis by summarizing the ratios into their five key
areas: liquidity, activity, debt. profitability, and
market. Each of the key areas could then be
summarized. highlighting specific ratios that
should be investigated.
20. The DuPont system of analysis combines

profitability (the net profit margin), asset
efficiency (the total asset turnover) and leverage
(the debt ratio). The division of ROE among these
three ratios allows the analyst to segregate the
specific factors that are contributing to the ROE
into profitability. asset efficiency, or the use of
debt.

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1.

The role of the Financial Accounting Standards

Market ratios give insight into how well

The liquidity and debt ratios are most important to

19. The analyst may approach a complete ratio

20. The DuPont system of analysis combines

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