Page 1 of 21 Chapter 5: Balance Sheet and Statement of Cash Flow Balance Sheet: Financial position of a firm at a particular point

in time; Provides information about the nature and amounts of investments in enterprise resources, obligations to creditors, and the owners equity in net resources. Helps predict amounts, timing, and uncertainty of future cash flows.

1) Usefulness of the Balance Sheet: The balance sheet is useful for analyzing a companys liquidity, solvency, and financial flexibility. a b c Liquidity: How quickly assets can be converted into cash. Solvency: How easily a company can pay its debt. Financial Flexibility: Ability to alter amounts and timing of cash flows as necessary. 2) Limitations of the Balance Sheet: a

In other words, the Balance Sheet information is highly reliable but not necessarily as relevant. b

(e.g., employees knowledge and skill, customer base, research superiority, and reputation.) Also, some company obligations are omitted (e.g., certain types of lease arrangements.)

Page 2 of 21 3) Classification in the Balance Sheet: a General: i) Balance Sheet Classification: similar items are grouped together to arrive at significant subtotals. ii) Report individual items separately. Such detail allows users to better assess the amounts, timing, and uncertainty of future cash flows. (For example, if a user can see the individual amount of Accounts Receivable, he can estimate the amount of cash to be received in the next year from current year A/R.) It also helps in evaluating liquidity and financial flexibility, profitability, and risk. (For example, a user can estimate liquidity by observing individual debt amounts.) iii) The three general classes of items included in the balance sheet are: (1) Assets: Probable future economic benefits owned or controlled by the entity. Assets include: (a) (b) (c) (d) (e) (2) Liabilities: Probable future sacrifices of economic benefit (results from past transactions or events.) Liabilities include: (a) (b)

Page 3 of 21 (3) Equity: Residual interest (i.e., what is left over) in the assets of an entity that remains after deducting its liabilities. Owners Equity includes: (a) (i) (ii) (b) (c) (d) (e) (Note: Items listed in each section above are not all-inclusive; however, they are typical of almost all Balance Sheets.) b Current Assets:

Some exceptions exist: Example: Investment in common stock is classified as either a current asset or a non-current asset depending on managements intent. Investments in small holdings of common stocks or bonds that are going to be held for a long period of time.

Operating Cycle:

Page 4 of 21 Current Assets are presented in the balance sheet _________________________.

Each section is presented below in the __________________________________. (Note: These 5 items are not considered current assets if they are not expected to be realized in one year or in the operating cycle, whichever is longer.) i) Cash: (1) Valuation: (2) Must disclose any restrictions. Depending on the circumstances, restricted cash may be in current assets or non-current assets. See Illustration 5-2 on page 173. ii) Short-Term Investments: (1) Valuation: (2) Investments in debt and equity securities are grouped into three separate portfolios for valuation and reporting purposes. (a) Held-to-maturity: Debt securities intended to be held to maturity (e.g., hold a bond until it expires.) Classified as current or non-current depending on the circumstances.

(b) Trading: Debt and equity securities expected to be sold in the near future.

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(c) Available-for-sale: Debt and equity securities not classified as heldto-maturity or trading securities. Classified as current or non-current depending on the circumstances.

iii) Receivables: (1) Valuation: (2) Clearly identify any anticipated loss due to uncollectible accounts, the amount and nature of any non-trade receivables, and any receivables designated or pledged as collateral. iv) Inventories: (1) Valuation: (2) Must disclose valuation basis (i.e., lower of cost or market LCM) and pricing method (e.g., FIFO, LIFO, etc.) Also, the stage of completion of manufactured inventories should be disclosed (i.e., Raw Materials, WIP, and Finished Goods.) See Illustrations 5-7 on page 176. v) Prepaid Expenses: (1) Valuation: (2) Expenditures already made for benefits (usually services) to be received within one year or the operating cycle, whichever is longer. (3) Include as current assets even though they do not technically meet the definition of a current asset; never convert into cash or used to pay a liability, just use up. (4) Insurance and other prepayments for longer than one year are often included in current assets even though part of the advance payment applies

Page 6 of 21 to periods beyond one year or the current operating cycle. (Could also be included in other asset section as deferred charge.) (5) Examples: c Non-Current Assets: i) Long-Term Investments: Investments held for many years. Not acquired with the intention of selling in the near future. (1) Investments normally consisting of one of four types: (a) Investments in securities Why hold these?

(b) Investments in tangible fixed assets not currently used in operations.

(c) Investments set aside in special funds such as

(d) Investments in non-consolidated subsidiaries or affiliated companies.

Page 7 of 21 (2) Depending on managements intent, classified as either Available-for-Sale or Held to Maturity. ii) Property, Plant, and Equipment: Tangible, long-term fixed assets acquired for use in main operations. (In practice, a detailed classification of PPE is disclosed in a supplementary schedule rather than on the face of the balance sheet.) (1) Land: (2) Buildings, equipment, furniture, fixtures: (If equipment is held for sale, include it separately in the current asset section or include it in the investment section.)

(3) Natural Resources: (4) Capitalized leases:

iii) Intangible Assets: IA have no physical substance but they convey value because of ownership rights. (1) Examples: (a)

(b) (c)

Page 8 of 21 (d)

(2) Reporting: (a) Limited-life intangibles are written off (amortized using straight-line method) over their useful lives. (b) Indefinite-life intangibles (e.g., goodwill) are not amortized, but are periodically assessed for impairment. (c) Expenditures for intangible assets such as most R&D (Research and Development) and internally-developed goodwill are not capitalized but are expensed as incurred.) iv) Other Assets: (1) Examples: Deferred charges (long-term prepaid expenses), non-current receivables, intangible assets, assets in special funds, deferred income taxes. (2) Section tends to be too general. It should be restricted to unusual items sufficiently different from assets included in special categories.

v) Classification of Assets: Depends on the nature of item and the use of item. For example: (1) Land used as factory site (2) Land owned by a realty company and held for sale (3) Land held for speculation (4) Idle land and facilities that have been withdrawn from production d Liabilities: i) Current Liabilities (CL):

Page 9 of 21 (1) Obligations expected to be settled using current assets or creating current liabilities. (2) Examples: (a) Payables resulting from acquiring goods and services (e.g., accounts payable, wages payable, taxes payable.) (b) Unearned Revenue: Collections received in advance for delivery of goods or performance of services. (c) Other liabilities whose liquidation will take place within the operating cycle (e.g., portion of long-term bonds payable in current year, shortterm obligations arising from equipment purchase.) (3) Current Liabilities are not reported in a consistent order. However, they are frequently reported in the order they will be paid.

(4) Some liabilities that will be paid within a year are reported as long-term liabilities. These include: (a) If debt is refinanced through another long-term debt issuance (b) If debt is retired out of non-current assets. (5) Working Capital:

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ii) Long-Term Liabilities: (1) Obligations that are not reasonably expected to be liquidated within the normal operating cycle. (2) Examples: (a) Obligations from Specific Financing: (i) (ii) (iii) (iv) (b) Obligations from Ordinary Operations: (i) (ii)

(c) Obligations dependent on the occurrence and outcome of future events:

(i) (ii)

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(3) The currently maturing portion of long-term debt is classified as a current liability. (4) Supplementary Information Typically Disclosed: Debt covenants/restrictions; maturity dates; interest rates; amount of securities pledged to support debt. e Owners Equity: i) General: (1) Contributed Capital (i.e., Capital Stock): (a) (b) (c)

(d) Can have APIC for Preferred Stock, Common Stock, Common Stock Subscribed, and Treasury Stock. (These amounts can be presented as one total sum or as individual amounts.)

(2) Retained Earnings: Accumulated earnings of the company over its life less any dividends distributed to stockholders. This section may be divided between unappropriated (amount available fore dividend distribution) and any amounts that are restricted (e.g., bond indentures or other loan agreements.)

Page 12 of 21 (3) Accumulated Other Comprehensive Income: See Chapter 4. If amount represents income (loss), it is an addition (subtraction). (4) Treasury Stock

ii) Must disclose capital stock authorized, issued, and outstanding par value amounts. f Balance Sheet Format: i) Account form: Lists assets by sections on the left side, and liabilities and stockholders equity by sections on the right side. ii) Report form: Lists liabilities and stockholders equity directly below assets on the same page. (See Illustration 5-15 on page 182.)

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iii) Example following report form format: Company Name Balance Sheet December 31, 20xx Assets Current Assets Cash Receivables Inventory Prepaid Expenses Total current assets Long-Term Investments Available for sale securities

Property, plant, and equipment Land at cost Buildings at cost Less: Accumulated depreciation Equipment at cost Less: Accumulated depreciation Total property, plant, and equipment Intangible assets Goodwill

Total assets

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Liabilities and Stockholders Equity Current liabilities Accounts payable Notes payable Income taxes payable Accrued liabilities

Total current liabilities Long-term Liabilities Bonds Payable Long Term Debt Deferred income taxes Total liabilities Stockholders equity Preferred Stock

Common Stock

APIC Retained Earnings Accumulated other comprehensive income Total stockholders equity Total liabilities and stockholders equity

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Altmans Z-score: This is a bankruptcy-prediction model that can be used to help evaluate the overall financial position and trends of a firm.
WorkingCapital Re tainedEarnings EBIT 1.2 + 1.4 + 3 .3 TotalAssets TotalAssets TotalAssets Sales MVEquity + 0.99 + ).6 TotalAssets TotalLiabi lities Z =

Companies with z-scores above 3.0 are unlikely to fail. Companies with z-scores below 1.81 are very likely to fail. (I doubt that I will test you on this but you should be aware of this model when you are practicing accounting.) 4) Additional Information Reported: a Contingencies: Material events that have an uncertain outcome. (Examples: Uncertain gains/losses from litigation; uncertain gains/losses from environmental issues; uncertain gains/losses from on-going governmental investigations.) Include as Long Term Liability if loss is probable and estimable.

Accounting Policies: i) Describe all significant accounting principles and methods that involve selection from among alternatives and/or those that are peculiar to a given industry. ii) Disclose information about nature of operations, use of estimates in preparing financial statements, certain significant estimates, and vulnerabilities due to certain concentrations. (That is, disclose information about risks and uncertainties involved in operations.) iii) This information is typically given in a Summary of Significant Accounting Policies. This note either precedes the footnotes or is the first footnote. (I have always seen this as the first footnote.) See Procter & Gamble example, Note 1, page 211 to 213.

Page 16 of 21 c Contractual Situations: Significant contractual situations should be disclosed in financial statement notes. i) It is MANDATORY to disclose provisions of lease contracts, pension obligations, and stock option plans in the notes. ii) Commitments related to obligations to maintain working capital, to limit the payment of dividends, to restrict the use of assets, and to require the maintenance of certain financial ratios must all be disclosed if material. iii)

Fair Values: Financial Instruments: Cash, an ownership interest, or a contractual right to receive or obligation to deliver cash or another financial instrument. i) Can be either assets or liabilities:

ii) Both carrying value and estimated fair value of financial instruments must be disclosed. (See Illustration 5-18 on page 187.) 5) Techniques of Disclosure: a b c Parenthetical Explanations: Notes: Cross Reference and Contra Items: Remember, a contra account on a balance sheet is

An adjunct account

Page 17 of 21 d e Supporting Schedules: Terminology: Use of the term surplus is discouraged. The term reserve should be used only to describe an appropriation of retained earnings. 6) Purpose of the Statement of Cash Flows: a Remember that assessing the amounts, timing, and uncertainty of cash flows was presented as one of the three basic objectives of financial reporting in Chapter 2. The Statement of Cash Flow helps meet this objective. It is a required statement.

Purposes of Statement: i) Primary Purpose:

ii) To summarize the operating, investing, and financing activities of the business. c Reporting sources, uses, and net increase/decrease in cash helps investors, creditors, and others know what is happening to a companys most liquid resource. This statement provides answers to the following questions: i) ii) iii)

Page 18 of 21 d Helps evaluate liquidity, solvency, and financial flexibility. i) Liquidity: ii) Solvency: iii) Financial Flexibility:

7) Content and Format of the Statement of Cash Flows: Cash receipts and cash payments during a period are classified in the statement of cash flows into three different activities operating, investing, and financing activities. a Operating activities:

Investing activities:

Specific Examples:

Page 19 of 21 c Financing activities:

Specific Examples:

Basic Format: Illustration 5-24, page 192 HEADING Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities Net increase (decrease) in cash Cash at beginning of year Cash at end of year

8) Preparation of the Statement of Cash Flows: a Info needed to prepare CF Stmt comes from: i) ii) iii)

Page 20 of 21 b In preparing CF Stmt, one must: i) Determine cash provided by operations. ii) Determine cash provided by/used in investing and financing activities. iii) Determine change in cash during period. iv) Reconcile change in cash with beginning and ending cash balances. c Cash from Operations: The excess of cash receipts over cash payments. Determined by converting net income on an accrual basis to a cash basis. This is accomplished by adding to or deducting from net income those items in the income statement not affecting cash. This procedure requires an analysis not only of the current years income statement but also of the comparative balance sheets and selected transaction data.

Formula:

d e

See Illustration 5-30, Comprehensive Statement of Cash Flows on page 195. Significant non-cash transactions: i) All significant financing and investing activities must be disclosed in the CF statement or notes, even though cash is not affected.

Page 21 of 21 ii) Examples: (1) (2)

9) Usefulness of the Statement of Cash Flows: For small and newly developing companies, cash flow is the single most important element for survival. Even medium and large companies indicate a major concern in controlling cash flow. Companies can fail even tough they are profitable. Net income and net cash provided by operating activities can be substantially different. The reasons for the difference between a positive net income and a negative net cash provided by operating activities are substantial increases in receivables and/or inventories. a Financial Liquidity:

Financial Flexibility:

Free Cash Flow: