Duration: 60

mins
Slides: 16

LMT SCHOOL OF MANAGEMENT, THAPAR

UNIVERSITY
Masters of Business Administration

Course: Financial Reporting and Analysis

Faculty: Dr. Sonia Garg (Email:
sonia.garg@thapar.edu)

Session 2: Understanding Financial Statements:

Balance Sheet

Certain concepts
Money Measurement: In financial accounting a record is
made only of information that can be expressed in
monetary terms
Entity: Accounts are kept for entities, as distinguished
from the persons who are associated with these entities
Cost: Non-monetary assets are ordinarily entered
initially in the accounting records at the price paid to
acquire it-at its cost (brings objectivity)
Dual-Aspect: Assets = Liabilities + Owners Equity
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Understanding Financial Statements: Balance

Sheet

A Simple Balance Sheet

ABC COMPANY
BALANCE SHEET
AS OF JUNE 1, 2014

Name of
Entity

Application of Funds: Assets

Sources of Funds: Liabilities &

Owners Equity
Rs. 50,000 Notes Payable
Rs. 50,000

Cash
Inventory
Total assets

50,000 Owners Equity

Rs.100,000

Total capital

50,000
Rs.100,000

Assets =
Liabilities +
Owners Equity

All items
expressed in
monetary terms

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Understanding Financial Statements:

Balance Sheet

ABC COMPANY
BALANCE SHEET
AS OF JUNE 1, 2014
Application of Funds: Assets
Sources of Funds: Liabilities &
Owners Equity
Cash
$
Accounts payable
$ 241,000
89,000
Marketable securities
379,000 Taxes payable
125,000
Accounts receivable

505,000 Accrued expenses

107,000

Inventories

Current
513,000 liabilities

473,000

Current assets

1,486,000 Notes payable

200,000

230,000 Bonds payable

700,000

Buildings

1,120,000 Total liabilities

1,373,000

Accumulated
depreciation

(538,000)

Land

Equipment
Accumulated
depreciation
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Investments

A More
Detailed
Balance Sheet
Name of
Entity
All items
expressed in
monetary terms
Monetary assets
like inventories
maybe recorded at
fair value

761,000 Owners Equity

(386,000) Capital stock

1,000,000

Understanding Financial Statements: Balance

Retained earnings Sheet
620,000

320,000

Non-monetary
assets like land
and building
recorded at cost
Assets =
Liabilities +
Owners Equity

Assets
Assets are resources controlled by an enterprise as a result of past events,
from which future economic benefits are expected to flow to the
enterprise
Key Characteristics
Future Economic Benefits
Used in production of goods or services, machinery
Exchanged for other assets, inventory
Used to settle a liability, cash
Distributed to owners of the enterprise, cash

Physical form is not necessary, copyrights and patents

Legal right of ownership not necessary, hire-purchase
Purchase or production may not be necessary but should be acquired, land
grant
Incurring expenditure sometimes may not lead to creation of assets,
unsuccessful digging of oil wells
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Understanding Financial Statements:

Balance Sheet

Classification of Assets
Current Assets
Cash
Marketable Securities are investments that are marketable and expected to
be converted into cash within a year
Accounts Receivable are amounts owed to the entity by its customers,
these are reported less the provision for doubtful debts
Notes receivable is amount owed to entity by parties other than customers
Inventories are either held for sale, in process of production or to be
consumed in production
Prepaid expenses are assets whose usefulness will expire in the near future

Plant, Property and Equipment are fixed assets that are relatively
long-lived. They are acquired to be used in production of goods and
services. Reported at original cost less accumulated depreciation.
Other assets
Investments are securities of other companies
Intangible assets like goodwill, patent, copyright
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Understanding Financial Statements:

Balance Sheet

Liabilities
Liabilities are the present obligations of the enterprise, arising from past events,
the settlement of which is expected to result in an outflow of resources
embodying economic benefits
Key Characteristics
Present obligations to be settled in future
Payment of cash
Transfer of other assets, inventories
Provision of services, consulting or technical know how
Replacement of an obligation with another, debentures to equity

Obligations may be legally enforceable as a consequence of a binding contract

Normal business practices to maintain good relations, product call backs
A present obligation is different from a future commitment, obligation arises only
when asset is delivered not when it is decided to be acquired (or when the firm
enters into an irrevocable agreement to acquire the asset)
Future rebates based on annual sales can also be recognized as liabilities
Provisions (for existing warranties and retirement benefits) may require high
degree of estimation
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Understanding Financial Statements:

Balance Sheet

Classification of Liabilities
Current Liabilities
Accounts payable are claims of suppliers arising from their
furnishing goods and services to the entity
Taxes payable shows the amount the entity owes
government agencies for taxes
Accrued expenses represent amounts that have been
earned by outside parties but have not yet been paid
Deferred Revenues (Unearned revenues) represents the
liability that arises due advance payments received by the
entity

Non-current liabilities
Long-term debt
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Understanding Financial Statements:

Balance Sheet

Owners Equity
Equity is the residual interest in the
assets of the enterprise after
deducting all its liabilities
Key Characteristics
It may be sub-classified into equity or
paid-in-capital, retained earnings and
other reserves
Sometimes law requires creation of
reserves like debenture redemption
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Understanding Financial Statements:

Balance Sheet

Recognition of items in B/S

An item is recognized when
Its is probable that any future economic benefits associated with the item
will flow to or from the enterprise (probable: non-payment of
receivables, so allow for provision of doubtful debts)
The item has cost or value that can be measured with reliability
(reasonable estimate: if it is not possible do not recognize, damages
payable in law suit can not be estimated thus they should not be
recognized but disclosed in Notes)
Assets are not recognized when expenditure has been incurred and it is
improbable that the future economic benefits will flow to the enterprise
beyond the current accounting period
Liabilities are not recognized in cases of obligations under contracts that
are equally proportionately unperformed
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Understanding Financial Statements:

Balance Sheet

10

Measurement Bases
They could be
Historical cost
Current cost
Realizable value
Present value
Historical cost is most commonly used base.
Inventories are usually carried at the lower of
historical cost and net realizable value
Retirement benefits are carried at their present value

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Understanding Financial Statements:

Balance Sheet

11

Changes in B/S
All changes in the B/S are such that the basic
accounting equation holds, thus a change could be
the following forms
Increase a liability and decrease a liability
Increase an asset and decrease an asset
Increase a liability and increase an asset
Decrease a liability and decrease an asset
An expense item will reduce the retained earnings in
the B/S and a revenue item will increase the
retained earnings in the B/S
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Understanding Financial Statements:

Balance Sheet

12

PROBLEMS

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Understanding Financial Statements:

Balance Sheet

13

Problem 2-3
1. Cash + $100,000; Capital stock + $100,000.
2. Bonds payable - $25,000; Capital stock + $25,000.
3. Retained earnings (Depreciation expense) - $8,500.
Accumulated depreciation on plant and equipment +
$8,500.
4. Cash - $15,900; Inventory + $15,900.
5. Inventory + $9,400; Accounts payable + $9,400.
6. Inventory - $4,500; Accounts receivable + $7,200;
Retained earnings + $2,700
7. Cash + $3,500; Accounts receivable - $3,500.
8. Dividends payable + $3,000; Retained earnings - $3,000.
9. Cash - $3,000; Dividends payable - $3,000.
10.No effect.

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Understanding Financial Statements:

Balance Sheet

14

Problem 2-4

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Understanding Financial Statements:

Balance Sheet

15

Problem 2-5
Jan. 4: Retained earnings (Sales) + $12,000; Cash + $12,000 Inventory - $7,000
;Retained earnings (Cost of goods sold) - $7,000
Jan. 6: No effect.
Jan. 8: Inventory + $7,000; Accounts Payable + $7,000
Jan. 11: Inventory - $1,500; Cash + $2,500; Retained earnings (Sales) + $2,500;
Retained earnings (Cost of goods sold) - $1,500
Jan. 16: Inventory - $2,000; Retained earnings (Cost of goods sold) - $2,000; Accounts
receivable + $3,400; Retained earnings (Sales) + $3,400
Jan. 26: Cash - $4,200; Retained earnings (Wages) - $4,200
Jan. 29: Cash - $20,000; Land + $20,000
Jan. 31: Cash - $2,800; Prepaid insurance + $2,800

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Understanding Financial
Statements: Balance Sheet

16