balance sheet component

8/11/2019 balance sheet component

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Chapter 2The Balance Sheet

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall 2-1


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Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

The Balance Sheet

Also called the statement ofcondition or the statement of

financial position Shows the financial condition of

a company on a particular date

Summarizes what the firms ownsand what the firm owes tooutsiders and to internal owners

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Financial Condition

Assets are what the firm owns.

Liabilities are what the firm owesto outsiders.

Stockholders equity is what thefirm owes to internal owners.

equityrs'StockholdesLiabilitieAssets

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Financial Condition

Consolidation

Parent company owns morethan 50% of voting stock.

Financial statements arecombined.

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Financial Condition

Balance Sheet Date

The date the balance sheet isprepared

Could be the end of thecalendar year, fiscal year,quarter, etc.

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Financial Condition

Comparative Data

SEC requires two-year auditedbalance sheets.

Provides a reference point fordetermining changes infinancial position

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Financial Condition

Common-Size Balance Sheet

Expresses each item on the balance sheet as apercentage of total assets

Reveals the composition of assets

Form of vertical ratio analysis

Useful for evaluating trends within a firm

Allows for making industry comparisons

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Financial Condition

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Assets

Segregated according to how they

are utilized Current Assets

Property, Plant, andEquipment

Other Assets

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Assets

Current Assets

Expected to be converted tocash within one year or oneoperating cycle

Continually used up andreplenished

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Assets

Current Assets

Operating cycle Time required to purchase or

manufacture inventory, sell theproduct, and collect the cash

Working capital Also called net working capital

Current assets less current liabilities

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Assets

Current Assets

Cash and cash equivalents

Marketable securities

Accounts receivable

Inventories

Prepaid expenses

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Assets

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Assets

Current Assets Cash and CashEquivalents

Cash awaiting deposit

Cash in a bank account

Short-term investments that canbe converted to cash within threemonths

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Assets

Current Assets MarketableSecurities

Short-term investments that can beconverted to cash within a year

Three categories

Held to maturity Trading securities

Securities available for sale

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Assets

Current Assets Accounts

Receivable Customer balances outstanding

on credit sales

Net realizable value actualamount of account less anallowance for doubtful accounts

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Assets

Current Assets AccountsReceivable

Allowance for doubtful accounts

Affects balance sheet valuation

Important in assessing earnings quality

Should reflect volume of credit sales, pastexperiences with customers, customerbase, credit policies, collections practices,and economic conditions

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Assets

The allowance account for Sage Inc.represents approximately 5% ofaccounts receivable:

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Assets

Current Assets Accounts

Receivable There should be a consistent

relationship between the rate

of change in sales, accountsreceivable, and the allowancefor doubtful accounts.

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Assets

Sage Inc.

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Assets

To analyze the preceding information, considerthe following:

Are all three accounts changing in the samedirections and at consistent rates of change?

If the direction and rates of change are notconsistent, what are possible explanations forthese differences?

If there is not a normal relationship betweenthe growth rates, what are possible reasonsfor the abnormal pattern?

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Assets

For Sage Inc.,

Sales, accounts receivable, and the allowance

for doubtful accounts have all increased. Allowance account has increased

appropriately in relation to accountsreceivable.

Sales have grown at a much greater rate. More sales in cash have probably been

collected.

Sage will probably experience fewer defaults.

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Assets

Current Assets Accounts Receivable

Additional information helpful to theanalysis of accounts receivable andthe allowance account is provided inthe schedule of Valuation andQualifying Accounts.

Additions Charged to Costs andExpenses

Deductions

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Assets

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Assets

Additions Charged to Costs and Expenses is theamount estimated and recorded as bad debtexpense each year on the income statement.

Deductions is the actual amount the firm haswritten off as accounts receivable they no longerexpect to recover.

Analyst should use this schedule to assess theprobability that the firm is intentionally over- or

underestimating the allowance account.

Sage Inc. appears to estimate an expense fairlyclose to the actual amount written of each year.

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Assets

Current Assets Inventories

Items held for sale

Items used in the manufactureof products that will be sold

Major revenue producer formost companies

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Assets


Retail companies

Finished goods

Manufacturing companies

Raw materials

Work-in-process Finished goods

Service oriented companies

Little to no inventory

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Assets

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Assets


Inventory Accounting Methods

Method used has considerable impact on financialposition and operating results.

Valuation is based on an assumption regarding theflow of goods, not the actual order in whichproducts are sold.

Cost flow assumption is made in order to matchthe cost of products sold to the revenue generated.

Disclosure of inventory cost flow assumption isfound in the notes.

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Assets



First in, first out (FIFO)

Last in, first out (LIFO)

Average cost

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Assets

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Assets

ExampleA new company in its firstyear of operations purchases five productsfor sale in the order and at the pricesshown. The company sells three of theseitems at the end of the year.

Item Purchase Price

#1 $5

#2 $7

#3 $8

#4 $9

#5 $11

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Assets

Cost flow assumptions

Resulting effect on the income statement andbalance sheet

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Assets



During a period of inflation, the LIFOmethod typically produces

the highest cost of goods sold expense

the lowest ending valuation of inventory

undervalued inventories on the balancesheet

cost of goods sold values at current cost ofinventory items

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Assets



During a period of inflation, the FIFOmethod typically produces

the lowest cost of goods sold expense

the highest ending valuation of inventory

inventory values on the balance sheet thatare at current cost

cost of goods sold values below the currentcost of inventory items

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Assets



During a period of deflation, the FIFOmethod typically produces

the highest cost of goods sold expense

the lowest ending valuation of inventory

undervalued inventories on the balancesheet

cost of goods sold values at current cost ofinventory items

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Assets



During a period of deflation, the LIFOmethod typically produces

the lowest cost of goods sold expense

the highest ending valuation of inventory

inventory values on the balance sheet thatare at current cost

cost of goods sold values below the currentcost of inventory items

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Assets

Current Assets Prepaid Expenses

Expenses paid in advance

Insurance

Rent

Property taxes

Utilities

Included in current assets if they expire withinone year or one operating cycle

Generally not material to the balance sheet

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Assets

Property, Plant, and Equipment (PP&E)

Encompasses a companys fixed assets

Not used up during annual operations

Produce economic benefits for more than oneyear

Have physical substance Shown at book value on the balance sheet

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Assets

Property, Plant, and Equipment (PP&E)

The relative proportion of fixed assets in a

companys asset structure will largely bedetermined by the nature of the business.

Manufacturing firms typically have higherpercentages of fixed assets than retailers orwholesalers.

Firms with newly purchased assets will havehigher percentages of fixed assets than firmswith older fixed assets.

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Assets

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Assets

Property, Plant, and Equipment

Land Buildings

Leasehold improvements

Construction in progress

Equipment

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Assets

PP&E Land

Property used in business

Not investment property

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Assets

PP&E Buildings

Buildings owned by thecompany

Stores

Corporate offices

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Assets

PP&E Leasehold Investments

Additions made to leased structures

Improvements made to leasedstructures

Revert to the property owner when thelease expires

Amortized by the lessee over theeconomic life of the improvement (orthe life of the lease)

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Assets

PP&E Construction in Progress

Costs of constructing newbuildings that are not yetcomplete

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Assets

PP&E Equipment

Original cost of machinery andequipment used in businessoperations

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Assets

PP&E Depreciation

Fixed assets (with the exception of

land) are depreciated over the periodof time they benefit the firm.

Method of allocating the cost oflong-lived assets

Original cost less estimated residualvalue is spread over the assetsexpected life.

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Assets

PP&E Depreciation Methods

Straight-line method allocated an

equal amount of expense to eachyear of the depreciation period.

Accelerated methods apportionslarger amounts of expense to earlier

years of the assets depreciable life. Units-of-production method bases

depreciation expense on actual use.

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Assets

ExampleAssume that Sage Inc.purchases an artificial ski mountain

for its Phoenix flagship store inorder to demonstrate skis and allowprospective customers to test-runskis on a simulated course. Thecost of the mountain is $50,000and is expected to have a five-yearuseful life and $0 salvage value atthe end of that period.

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Assets

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Assets

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Assets

Goodwill

Arises when one company acquires another

company for a price in excess of the fairmarket value of the net identifiable assetsacquired

Evaluated annually

If no loss of value has occurred, goodwillremains on the balance sheet.

If the book value exceeds the fair value, theexcess must be written off as an impairmentexpense

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Assets

Other Assets

Can include a multitude of other noncurrent

items Property held for sale

Start-up costs associated with a new business

Cash surrender value of life insurance

policies

Long-term advance payments

Intangible assets (other than goodwill)

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Liabilities

Represent claims against assets

Current liabilities Must be satisfied in one year or

one operating cycle

Noncurrent liabilities Obligations with maturities beyond

one year

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Liabilities

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Liabilities

Current Liabilities

Accounts payable

Notes payable

Current portion of long-termdebt

Accrued liabilities

Unearned revenue

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Liabilities

Current Liabilities Accounts Payable

Short-term obligations that arisefrom credit extended by suppliers forthe purchase of goods and services

Eliminated when the bill is satisfied

Increase and decrease depending oncredit policies, economic conditions,and cyclical nature of operations

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Liabilities

Current Liabilities Notes Payable

Also referred to as short-termdebt

Short-term obligations in theform of promissory notes

Lines of credit to suppliers orfinancial institutions

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Liabilities

Current Liabilities CurrentMaturities of Long-term Debt

Portion of the principal oflong-term debt that will be

repaid during the upcomingyear

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Liabilities

Current Liabilities Accrued Liabilities

Result from recognition of an expense prior

to actual payment of cash Reserve accounts

Set up for the purpose of estimatingobligations for items such as warranty costs,sales returns, or restructuring charges

Identified in the notes to the financialstatements

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Liabilities

Current Liabilities Accrued Liabilities

Example Assume that a company has a $100,000note outstanding with 12% interest due in semiannualinstallments on March 31 and September 30. For abalance sheet prepared on December 31, interest willbe accrued for three months (October, November,and December). The December 31 balance sheetwould include an accrued liability of $3,000:

$10,000 x 0.12 = $12,000 annual interest$12,000/12 = $1,000 monthly interest$1,000 x 3 = $3,000 accrued interest for three months

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Liabilities

Current Liabilities Unearned Revenue

Also called deferred credits

Result from payments received inadvance for services and products

Transferred to a revenue accountwhen the service is performed or theproduct is delivered

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Liabilities

Deferred Taxes

Result of temporary differencesin the recognition of revenue andexpense for taxable incomerelative to reported income

Depreciation methods are themost common source fortemporary differences.

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Liabilities

Deferred Taxes

Other temporary differences arise from

methods used to account for Installment sales

Long-term contracts and leases

Warranties and service contracts Pensions and other employee benefits

Subsidiary investment earnings

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Liabilities

Deferred Taxes

Permanent differences inincome tax accounting do notaffect deferred taxes.

Municipal bond revenue

Life insurance premiums

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Liabilities

Deferred Taxes

Valuation allowance Used to reduce deferred tax assets

to expected realizable amounts

Used when it is more likely thannot that some of the deferred taxassets will not be realized

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Liabilities

ExampleAssume that a company has a totalannual revenue of $500,000, expenses otherthan depreciation of $250,000, and a

depreciation expense of $100,000 for taxaccounting and $50,000 for financial reporting.The income for tax reporting purposes would becomputed two ways, assuming a 34% tax rate:

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Liabilities

Taxes actually paid ($51,000) are less thanthe tax expense ($68,000) reported in thefinancial statements. To reconcile the

$17,000 difference between the expenserecorded and the cash outflow, there is adeferred tax liability of $17,000:

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Liabilities

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Liabilities

Deferred Taxes

Deferred taxes are not always

classified as current liabilities.

They may also appear on the balancesheet as a

current asset noncurrent asset

noncurrent liability

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Liabilities

Noncurrent Liabilities

Long-term debt

Capital lease obligations

Postretirement benefits otherthan pensions

Commitments and contingencies

Hybrid securities

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Liabilities

Noncurrent Liabilities Long-term Debt

Bonds

Long-term notes payable

Mortgages

Obligations under leases

Pension liabilities

Long-term warranties

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Liabilities

Noncurrent Liabilities Capital LeaseObligations

Are, in substance, a purchase ratherthan a lease

Affect both balance sheet and incomestatement

Disclosures found in the notes, oftenunder both the PP&E note and thecommitments and contingencies note

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Liabilities

Noncurrent Liabilities Pensions andPostretirement Benefits

Pensions are cash compensation paid toretired employees.

Postretirement benefits are benefitsother than pensions that employerspromise to pay for retired employees.

Can appear under the liability section ofthe balance sheet

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Liabilities

Noncurrent Liabilities Commitments andContingencies

Commitments refer to contractualagreements that will have a significantfinancial impact in the future.

Contingencies refer to potential liabilities(such as possible damage awards assessed in

lawsuits). Intended to draw attention to the fact that

required disclosures can be found in thenotes to the financial statements.

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Liabilities

Noncurrent Liabilities HybridSecurities

Have the characteristics of both debtand equity

Also called mandatorily redeemablepreferred stock

Financial instrument is preferredstock, but the issuing company mustretire the shares at a future date.

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Stockholders Equity

Also called shareholdersequity

Residual interest in assets thatremains after deductingliabilities

Owners bear greatest risk andbenefit from greatest rewards.

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Stockholders Equity

Common Stock

Shareholders

do not ordinarily receive a fixed return

have voting privileges in proportion toownership interest

can benefit through price appreciation

can suffer through price depreciation

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Stockholders Equity

Common Stock

Dividends are declared at thediscretion of a companys board ofdirectors

Amount listed on the balance sheet is

based on the par or stated value of theshares issued (which bears norelationship to actual market price).

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Stockholders Equity

Additional Paid-In Capital

Reflects the amount by whichthe original sales price of thestock shares exceeded par

value

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Stockholders Equity

Retained Earnings

Sum of every dollar a company has

earned since inception less anypayments made to shareholders

Funds a company has elected toreinvest in the operations of the

business rather than pay out in stock Measurement of all undistributed

earnings

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Stockholders Equity

Retained Earnings

Key link between the income

statement and the balance sheet Unless there are unusual

transactions affecting the retainedearnings account,

Beginningretainedearnings

Netincome(loss)

Endingretainedearnings

Dividends =

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Stockholders Equity

Other Equity Accounts

Preferred stock

Accumulated other comprehensiveincome (expense)

Treasury Stock

Employee benefit trusts

Equity attributable to noncontrollinginterests

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Stockholders Equity

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Stockholders Equity

Other Equity Accounts

Preferred Stock Carries a fixed annual dividend

payment

Carries no voting rights

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Stockholders Equity

Other Equity Accounts Accumulated OtherComprehensive Income (Expense)

Unrealized gains or losses in the market value ofinvestments in available-for-sale securities

Any change in the excess of additional pensionliability over unrecognized prior service cost

Certain gains and losses on derivative financial

instruments Foreign currency translation adjustments

resulting from converting financial statementsfrom a foreign currency into U.S. dollars

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Stockholders Equity


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Stockholders Equity

Other Equity Accounts Treasury Stock

Repurchased shares of stock that arenot retired

Shown as an offsetting account

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Stockholders Equity


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Stockholders Equity

Other Equity Accounts EquityAttributable to Noncontrolling

Interests

Represents the equity interest a firmhas in companies whose financial

statement have been consolidatedwith the firms statements but that arenot 100% owned by the firm

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Quality of Financial


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Q yReporting

Economic recession of 2008 and manymarket gyrations since can be traced directlyto overvaluation of balance sheet assets.

When financial reporting does not reflecteconomic reality quality and usefulness aresignificantly impaired.

Type of debt used to finance assets,commitments and contingencies, and theclassification of leases relate directly toquality of financial reporting.

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Quality of Financial


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Q yReporting

Commitments and Contingenciesdisclosure in the notes to financialstatements provide importantinformation about off-balance sheetfinancing and other complexfinancing arrangements.

Enron is a prime example of a

company with enormous activityreported in the Commitments andContingencies disclosure.

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Other Balance Sheet Items


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Other Balance Sheet Items

Corporate balance sheets arenot limited to the accounts

described in this chapter.

The reader of annual reportswill encounter additional

accounts and will find many ofthe same accounts listed underdifferent titles.

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Copyright Notice


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Copyright Notice

All rights reserved. No part of this publication may bereproduced, stored in a retrieval system, or

transmitted, in any form or by any means, electronic,mechanical, photocopying, recording, or otherwise,without the prior written permission of the publisher.Printed in the United States of America.

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