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The Balance Sheet Statement

Learning Objectives
1.How

balance sheet accounts are measured, classified and presented.


2.How

balance sheet information is used.

3.Balance

sheet terminology and format outside the U.S. 4.How footnotes aid to the understanding of the firms accounting policies, contingent liabilities, subsequent events, and relatedparty transactions
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The Accounting Equation


Assets = Liabilities + Equity

Shareholders Equity: Whats left of the companys assets after paying off liabilities. It also referred to as net assets.

Balance sheet classification:


Overview
ASSETS
=

LIABILITIES

EQUITY

Current

assets Property, plant and equipment Investments Other assets

Current

liabilities Long-term debt Other liabilities


Preferred

and common stock Additional paid-in capital Retained earnings

Contributed Capital

Elements of the balance sheet


How the money is invested

Where the money came from


=

ASSETS

LIABILITIES

EQUITY

Probable

future economic benefits Obtained from past transactions or events


Probable

future sacrifices of economic benefits Arising from present obligations To transfer assets or provide services in the future As a result of past transactions or events The residual interest in net asset

Balance sheet Classification and Account Measurement - Current assets

Amortized cost or current market value


Net realizable value

Lower of cost or current market value


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Assets classification and measurement


n

Resources with future economic benefit to a business entity as a result of a past transaction. Current Assets: cash and other assets that are reasonably expected to be realized in cash or sold, or consumed during a normal operating cycle or one year, whichever is longer Examples: Cash and cash equivalents, shortterm investments (reported at the fair value), receivables (estimated amount collectible), inventory (LCM), prepaid expenses, etc.
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Balance Sheet Classification and Account Measurement -PPE, Investments and Intangibles

Historical cost minus accumulated depreciation except that fair market value is used when impaired

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Assets (contd.)
Long-term Investments: Comprise of the following
Securities (i.e., bonds, stock, long-term notes) Fixed assets (i.e., land, building) Special funds (i.e., pension fund, bond sinking fund) Nonconsolidated subsidiaries or affiliated companies
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Assets (contd.)
Property, Plant, Equipment (i.e., building, Land, Machinery and equipment, capital leases): assets used in firms operations and meet the following criteria:
1. Economic life > 1 year; 2. Acquired for use in operation; 3. Not for resale to customers;

4. $ is material. (materiality)
Depreciation will be applied except for land.
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Assets (contd.)
Intangible Assets: assets with no physical substance but have value based on rights or privileges that belong to the owner (i.e., goodwill, patents, franchises, trademarks,). Amortization for limited life intangibles (i.e., patents, franchises) and impairment test for indefinite-life intangibles (i.e., goodwill).
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Balance Sheet Classification and Measurement - Liabilities

Amount due at maturity Historical cost

Discounted present value

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Liabilities
n

Legal obligations required future payments of assets or services as a result of a business entitys past transactions or events. A. Current Liabilities B. Long-term Liabilities C. Other Liabilities
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A. Current Liabilities
n

Obligations must be fulfilled in one year or one operating cycle, whichever is longer. (will require the use of current assets or the creation of current liability) (i.e., A/P, N/P, accrual payable, unearned revenue, income tax payable, current portion of L-T debt)
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Contingent Liabilities
n

Obligations may arise because of the occurrence or not occurrence of future event(s). (i.e., warranty obligations)

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B. Long-Term Liabilities
n

Obligations are not due in next year or next operating cycle, whichever is longer. (i.e., bonds payable, pension liability)

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C. Other Liabilities
n

Long-term advances from customers, deferred income taxes.

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Balance Sheet Classification and Account Measurement -Stockholders equity


Historical par value

Historical cost

Combination of different measurement bases


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Stockholders Equity
n

Residual claims (assets-liabilities) to the business entity from stockholders including:


a. contributed capital b. (+ or -)Accumulated Other Comprehensive Income c. retained earnings (or - deficit) d. (-)treasury stock
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a. Contributed Capital
n n

Par value of common stock Par value of prefer stock

Paid-in capital in excess of par value of common stock or preferred stock

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b. Accumulated Other Comprehensive Income


n

Increase of assets without outflows of assets, increase of liabilities, increase of income or issuance of common stock (i.e.,(+) increase in market value of securities-available-for-sale (+ or -), gains or losses of foreign currency adjustments, etc.)
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c. Retained Earnings
n

Net income not distributed to stockholders


u u

appropriated
unappropriated

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Balance sheet information


1. Rates of return
ASSETS
Helps

ROA and ROCE

2. Capital structure Debt vs. Equity

LIABILITIES + EQUITY

assess

3. Liquidity 4. Solvency
5. Flexibility

Cash conversion Ability to pay debt

Balance Sheet

Operating and financial

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1. Rate of Return Ratios

ROA (return on assets) and ROCE (return on common equity) ratios: Evaluate operating efficiency and profitability. ROA = Net operating profit after taxes (NOPAT) / Average assets ROCE = (Net income Preferred dividends) / Average common shareholders equity
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2. Capital Structure
The balance sheet provides critical information for understanding an entitys capital structure. Capital structure refers to how much of an entitys assets are financed from debt versus equity sources.

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3. Liquidity Ratios

Liquidity measures how readily assets can be converted to cash relative to how soon liabilities will have to be paid in cash. Current ratio: Indicate the level of current resources available to pay current debts. Current Ratio = Current Assets / Current
Liabilities

Question: Does higher ratio always indicate better financial status?


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4. Solvency

Solvency defines the ability of a company to generate sufficient cash flows to maintain its productive capacity and still able to pay off the long-term debt. Debt ratios provide information about the amount of long-term debt in a companys financial structure. Long-term debt to assets = Long term debt/Total assets
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Solvency (contd.)

A company that can not make timely payments in the amount required becomes insolvent and may be compelled to reorganize or liquidate.

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5. Flexibility

Flexibility refers to the ability to adapt or revise to a new strategy for different circumstances. The ability to adjust to unexpected downturn in the economic environment in which it operates or to take advantage of profitable investment opportunities when they arise.
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Analytical insights:
Understanding the business

Which company is: Deere E-Trade Potomac Electric Power Wal-Mart

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Balance sheet presentation:


International differences
U.S. Format:
Current Assets

U.K. Format:
Fixed Assets

+
Long-lived Assets

+
Current Assets

=
Current Liabilities

Current Liabilities

Non-current Liabilities

+
Non-current Liabilities

+
Stockholders Equity

=
Capital Employed

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Financial statement footnotes

Footnotes are an integral part of companies financial reports. These notes help users better understand and interpret the numbers presented in the body of the financial statements. Three important notes:
1. Summary of significant accounting

policies. 2. Subsequent event disclosures. 3. Related party transactions

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Limitations of the Balance Sheet


n

1. Historical costs reporting for most of assets and liabilities. 2. Estimations involved in the value of some assets and liabilities (i.e., the net realizable value of accounts receivable and the cost of warranty). 3. the omission of some valuable items such as goodwill of the company. 4. Off-balance sheet liabilities.
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Summary
1.

The balance sheet shows the assets owned by a company at a given point in time, and how those assets are financed (debt vs. equity). Be alert for differences in balance sheet measurement bases, account titles, and statement format.

2.

3.

Financial statement footnotes provide important information..


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