CHAPTER 2 – REVIEWING FINANCIAL STATEMENTS

Questions

LG1 1. List and describe the four major financial statements.

The four basic financial statements are:
1. The balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time.
2. The income statement shows the total revenues that a firm earns and the total expenses the firm incurs to generate those revenues over a specific period of time—generally one year.
3. The statement of cash flows shows the firm’s cash flows over a given period of time. This statement reports the amounts of cash that the firm generated and distributed during a particular time period. The bottom line on the statement of cash flows―the difference between cash sources and uses―equals the change in cash on the firm’s balance sheet from the previous year’s cash account balance.
4. The statement of retained earnings provides additional details about changes in retained earnings during a reporting period. This financial statement reconciles net income earned during a given period and any cash dividends paid within that period on one side with the change in retained earnings between the beginning and ending of the period on the other side.

LG1 2. On which of the four major financial statements (balance sheet, income statement, statement of cash flows, or statement of retained earnings) would you find the following items?

a. earnings before taxes - income statement
b. net plant and equipment - balance sheet
c. increase in fixed assets - statement of cash flows
d. gross profits - income statement
e. balance of retained earnings, December 31, 20xx - statement of retained earnings
f. common stock and paid-in surplus - balance sheet
g. net cash flow from investing activities - statement of cash flows
h. accrued wages and taxes - income statement
i. increase in inventory - statement of cash flows

LG1 3. What is the difference between current liabilities and long-term debt?

Current liabilities constitute the firm’s obligations due within one year, including accrued wages and taxes, accounts payable, and notes payable. Long-term debt includes long-term loans and bonds with maturities of more than one year.

LG1 4. How does the choice of accounting method used to record fixed asset depreciation affect management of the balance sheet?

Firm managers can choose the accounting method they use to record depreciation against their fixed assets. Two choices include the straight-line method and the modified accelerated cost recovery system (MACRS). Companies often calculate depreciation using MACRS when they figure the firm’s taxes and the straight-line method when reporting income to the firm’s stockholders. The MACRS method accelerates deprecation, which results in higher deprecation expenses, lower taxable income, and lower taxes in the early years of a project’s life. The straight-line method results in lower depreciation expenses, but also results in higher taxes in the early years of a project’s life. Firms seeking to lower their cash outflows from tax payments will favor the MACRS depreciation method.

LG1 5. What are the costs and benefits of holding liquid securities on a firm’s balance sheet?

The more liquid assets a firm holds, the less likely the firm will be to experience financial distress. However, liquid assets generate no profits for a firm. For example, cash is the most liquid of all assets, but it earns no return for the firm. In contrast, fixed assets are illiquid, but provide the means to generate revenue. Thus, managers must consider the trade-off between the advantages of liquidity on the balance sheet and the disadvantages of having money sit idle rather than generating profits.

LG2 6. Why can the book value and market value of a firm differ?

A firm’s balance sheet shows its book (or historical cost) value based on Generally Accepted Accounting Principles (GAAP). Under GAAP, assets appear on the balance sheet at