ACCT311

DeGeorge

Chapter 5

Chapter 5 Balance Sheet and Statement of Cash Flows FASB Statement of Financial Concepts # 5 identifies the objectives of Financial statements. To present the user with: The financial position of the company The net income and comprehensive income for a period The cash flows for the period The investments from and distributions to the owners The four basic financial statements accomplish this primary objective. Footnotes are required to meet the qualitative characteristic of completeness. For a user, a complete set of financials with footnotes are still of little use. To be relied upon, the user needs to know that the financials were prepared In accordance with GAAP, i.e. the auditors report or opinion. Financial statements are interrelated in that the financial statements, taken as a whole, including the

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DeGeorge

Chapter 5

notes to the statements, present relevant and reliable information for a user. Purpose of a balance sheet is to provide information about the economic resources, obligations and owners equity so as to help users assess the amount, timing and uncertainty of projected cash flows. Whose projection? The users not the Preparers. Balance sheet = Assets = Liabilities + Equity. Or Assets Liabilities = Equity also referred to as net worth. However, the net worth or equity of a company on its balance sheet is not the value of the company. The value of a company is what a buyer is willing to pay. The balance sheet , along with the other financial statements, taken as a whole, provide a basis for users to determine the value. The balance sheet does show: (see ratios below) The liquidity of a company, how rapidly the net assets can be converted to cash The flexibility of a company, how easily the company can adapt to change, and The operating capability, can the company maintain its current level of operations.

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DeGeorge

Chapter 5

Additionally, the balance sheet provides a barometer for measuring the performance of the company, i.e. return on net assets. (Capital and Capital Maintenance) The key to a users ability use the financial data is A) the users knowledge of the financial data and B) the Preparers knowledge of financial data The two must be in sync.

ACCT311

DeGeorge

Chapter 5

The recognition principle (from chapter 2) identified that in order to recognize (or record) an item in the financial statements the item must: 1 fit the definition of the item 2 be measurable 3 be relevant and 4 be reliable. Key definitions Assets Liabilities Owners Equity is what is remains, assets liabilities as defined. Measurement of balance sheet items Historical cost most prevalent and most reliable Current or Replacement cost (input value) What we would have to pay to replace the item today Current Market Value (exit value) What we would expect to receive upon sale in its current condition Net Realizable Value cash expected to be realized (Accounts receivable less allowance for bad debts) Present Value similar to NRV but with the time value of money concept

ACCT311

DeGeorge

Chapter 5

Historical cost is most prevalent but all five are acceptable and sometimes required by GAAP. Limitations of the Balance Sheet Historical cost. (reliability versus relevance) B/S does not include all of the economic resources of the company. Value of employees Value of created intangibles These items cannot be measured and therefore are not reported. As long as the user is aware, this is not necessarily a problem.

ACCT311

DeGeorge

Chapter 5

Classification of Balance Sheet Items: Why? Summary financial information We can summarize like items. Cash is cash regardless of how many different checking accounts we use. How? Liquidity is the key. Balance sheet is arranged in the order of expected conversion to cash or in the case of liabilities the expected use of cash. Current Assets less Current Liabilities = Working Capital To be current the asset must be expected to be converted to cash or to be used in the operations of the business and the liability must be due or expected to be paid, within one year, or within the normal operating cycle, whichever is longer. The starting period of the one year or operating cycle is the balance sheet date. Current Assets / Current Liabilities = current ratio. This is a normal and key indicator of the liquidity of a company.

ACCT311

DeGeorge

Chapter 5

Total Liabilities/Owners Equity = debt to equity ratio. This is a normal and key indicator of the flexibility of a company. Investment in Property, plant and equipment can be an indicator of the operating capability of a company. Current Assets Cash and cash equivalents (risk free and maturing in less that 3 months) Temporary investments in marketable securities (intent is critical) Even if a marketable security (a bond) has a long-term maturity If the intent of the company is to buy and sell prior to maturity The item would be considered short term. Receivables Inventory Prepaids and other current assets Current Liabilities: Accounts payable Salaries Payable Unearned (deferred) revenue Income taxes payable Current portion of long-term obligations Other current liabilities

ACCT311

DeGeorge

Chapter 5

Long-term Assets Long-term Investments Investments which the company plans to hold till maturity versus trading Cash surrender value of life insurance policies Common, company pays the premium, employee identifies The beneficiary, upon death the company gets the CSV. Although The company could terminate the policy and receive the cash today The intent is to hold until death. Land or property purchased for future use but not currently in use. Property, Plant and Equipment, currently being used in the operations and expected to be used for more than one accounting period. Intangible Assets used in operations but have no physical existence. We cannot create these assets but we can buy them. Patents, Trademarks, Copyrights, Goodwill Other Assets deferred items

ACCT311

DeGeorge

Chapter 5

Long-term Liabilities Include all components such as bond premiums or discounts Stockholders Equity Legal capital = the amount of cash/value required by law to be maintained. Par Value is normally the legal capital. Contributed Capital = Par Value + Additional Paid in Capital Can relate to both common stock and preferred stock Retained Earnings = History to date net earnings less dividends Accumulated Other Comprehensive Income. Comprehensive income = the change in owners equity which Is NOT related to transactions with the owners. Other comprehensive income would exclude net income.

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DeGeorge

Chapter 5

Treasury Stock (a contra equity account) is the amount paid by the company to reacquire shares of previously issued and outstanding stock.

ACCT311

DeGeorge

Chapter 5

Other Disclosures: (Footnotes) Summary of accounting policies (APB Opinion #20) Fair Value and Risk (FASB #133) Contingent Liabilities and Contingent Assets Contingent Assets or Contingent gains are not reported in the financial statements. Contingent Liabilities are recorded in the financial statements if payment is probable, the amount can be reasonably estimated and the event causing the payment has occurred. Other contingent liabilities that are not recorded, are still required to be disclosed in the footnotes.

ACCT311

DeGeorge

Chapter 5

Statement of Cash Flows In General Operating Cash Flows Changes in Working Capital (excluding cash) Investing Cash Flows Changes in long-term assets Financing Cash Flows Changes in long-term liabilities & equity Sources and Uses of Cash Increases in Assets causes cash to decrease. What would cause PP&E to Increase? Decrease in Assets causes cash to increase. What would cause A/R to decrease? ALL ASSETS HAVE THE SAME EFFECT ON CASH Increase in Liabilities causes cash to increase. Why would Long-term debt increase? Decrease in liabilities causes cash to decrease. What would cause LT Debt to decrease? ALL LIABILITIES HAVE THE SAME EFFECT ON CASH Operating Cash Flows Indirect Method Net Income

ACCT311

DeGeorge

Chapter 5

+/- Non operating losses/gains (part of investing cash flows) +/- Non cash expenses/revenues +/- Changes in operating assets & liabilities = Cash flows from operating activities Investing Cash Flows - Cash used to acquire long-term assets + Proceeds from sale of LT assets (includes gain/loss on sale) = Cash flows from investing activities Financing Cash Flows + or Cash from/to lenders + or Cash from/to owners = Cash flows from financing activities