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Balance Sheet and disclosures

Balance Sheet and disclosures

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  • Chapter 3: The Balance Sheet and Financial Disclosures Chapter 1 stressed the importance of the financial statements in helping investors and creditors predict future cash flows. The balance sheet, along with accompanying disclosures, provides relevant information useful in helping investors and creditors not only to predict future cash flows, but also to make the related assessments of liquidity and long-term solvency. The purpose of this chapter is to provide an overview of the balance sheet and financial disclosures and to explore how this information is used by decision makers.
  • The purpose of the balance sheet, sometimes referred to as the statement of financial position, is to report a company’s financial position on a particular date. It is a freeze frame or snapshot of financial position at the end of a particular day marking the end of an accounting period. A limitation of the balance sheet is that assets minus liabilities, measured according to generally accepted accounting principles, is not likely to be representative of the market value of the entity. Many assets, like land and buildings, are measured at their historical costs rather than their market values. Relatedly, many company resources including its trained employees, its experienced management team, and its reputation are not recorded as assets at all. However, despite these limitations, the balance sheet does have significant value. The balance sheet provides information useful for assessing future cash flows, liquidity (refers to the period of time before an asset is converted to cash or until a liability is paid), and long-term solvency (the riskiness of a company with regard to the amount of liabilities in its capital structure).
  • The three primary elements of the balance sheet are assets, liabilities and Shareholders’ equity. The usefulness of the balance sheet is enhanced when assets and liabilities are grouped according to common characteristics. The broad distinction made in the balance sheet is the current versus noncurrent classification of both assets and liabilities.
  • This slide illustrates the asset section of Dell’s balance sheet. Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Notice that Dell classifies its assets as current and noncurrent.
  • Current assets include cash and all other assets expected to become cash or consumed within one year or the operating cycle, whichever is longer. Current assets includes cash, cash equivalents, short-term investments, receivables, inventories, and prepaid expenses. Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. Cash that is restricted for a special purpose and not available for current operations should not be classified as a current asset. Investments are classified as current if management has the ability and the intent to liquidate the investment in the near term. Accounts receivable result from the sale of goods or services on credit. Accounts receivables and financing receivables are valued net, that is, less the amount not expected to be collected. Inventories consist of assets that a retail or wholesale company acquires for resale or goods that manufacturers produce for sale. Prepaid expenses represent an asset recorded when an expense is paid in advance, creating benefits beyond the current period. Examples are prepaid rent and prepaid insurance.
  • The operating cycle for a typical manufacturing company refers to the period of time necessary to convert cash to raw materials, raw materials to a finished product, the finished product to receivables, and then finally receivables back to cash.
  • Noncurrent assets include investments, property, plant and equipment, intangible assets, and other long-term assets. Noncurrent assets are not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer.
  • Part I Investments are nonoperating assets not used directly in operations. This category includes both debt and equity securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes. Part II Tangible, long-lived assets used in the operations of the business are classified as property, plant, and equipment. This category includes land, buildings, equipment, machinery, and furniture as well as natural resources such as mineral mines, timber tracts, and oil wells. These items are reported at original cost less accumulated depreciation (or depletion for natural resources). Part III Intangible assets generally represent exclusive rights that a company can use to generate future revenues. This category includes patents, copyrights, and franchises. These items are reported net of accumulated amortization. Part IV Balance sheets often include a catch-all classification of noncurrent assets called other assets. This category includes long-term prepaid expenses and any noncurrent assets not falling in one of the other classifications.
  • Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities as a result of past transactions or events.
  • Current liabilities are expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer. Current liabilities include accounts payable, notes payable, accrued liabilities, and current maturities of long-term debt. Accounts payable are obligations to suppliers of merchandise or of services purchased on open account, with payment usually due in 30 to 60 days. Notes payable are written promises to pay cash at some future date (I.O.U.s). Unlike accounts payable, notes usually require the payment of explicit interest in addition to the original obligation amount. Notes maturing in the next year or operating cycle, whichever is longer, will be classified as current liabilities. Accrued liabilities represent obligations created when expenses have been incurred but will not be paid until a subsequent reporting period. Unearned revenues, sometimes called deferred revenues as in Google’s balance sheet, represent cash received from a customer for goods or services to be provided in a future period. When long-term debt is payable in installments, the installment payable currently is reported as a current liability under the caption, “Current Maturities on Long-Term Debt.”
  • Long-term liabilities are not expected to be satisfied through current assets or creation of current liabilities within one year or the operating cycle, whichever is longer. Long-term liabilities include long-term notes, mortgages, long-term bonds, pension obligations, and lease obligations.
  • Equity is simply a residual amount derived from subtracting liabilities from assets. For this reason, it’s sometimes referred to as net assets. Shareholders’ equity for a corporation arises primarily from two sources: paid-in capital (invested capital) and retained earnings (earned capital). Paid-in capital is represented by preferred and common stock which represent cash invested by shareholders in exchange for ownership interests. Retained earnings represents the accumulated net income earned since the inception of the corporation and not (yet) paid to shareholders as dividends. In addition to paid-in capital and retained earnings, shareholders’ equity may include a few other equity components, such as accumulated other comprehensive income, which we will learn more about in later chapters.
  • The management discussion and analysis (MDA) provides a biased but informed perspective of a company’s operations, liquidity, and capital resources. The MDA section of an annual report relates management’s biased perspective, however, it can offer an informed insight that might not be available elsewhere.
  • Management prepares and is responsible for the financial statements and other information in the annual report. Annual reports include a management’s responsibility section that asserts the responsibility of management for the information contained in the annual report as well as an assessment of the company’s internal control procedures.
  • Auditors examine financial statements and the internal control procedures designed to support the content of those statements. Their role is to attest to the fairness of the financial statements based on that examination. The auditors’ attest function results in an opinion stated in the auditors’ report. The auditors’ report provides an independent and professional opinion about the fairness of the representation in the financial statements and about the effectiveness of internal controls. Every audit report looks similar because it must comply with specifications of the Public Companies Accounting Oversight Board.
  • Part I There are four types of audit opinions. An unqualified opinion is issued when the financial statements present fairly the financial position, results of operations, and cash flows are in conformity with generally accepted accounting principles. Sometimes, circumstances cause the auditors’ report to include an explanatory paragraph in addition to the standard wording, even though the report is unqualified. Most notably, these include: lack of consistency due to a change in accounting principles, uncertainty as to the ultimate resolution of a contingency, and emphasis of a matter concerning the financial statements. Part II A qualified opinion is issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole. Examples of exceptions are nonconformity with generally accepted accounting principles, inadequate disclosures, and a limitation or restriction of the scope of the examination. Part III An adverse opinion is issued when the exceptions are so serious that a qualified opinion is not justified. Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report. Part IV A disclaimer opinion is issued when insufficient information has been gathered to express an opinion.
  • End of Chapter 3.

Chap003.interm Chap003.interm Presentation Transcript

  • The Balance Sheet and Financial Disclosures 3 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
  • The Balance Sheet
    • Limitations:
    • The balance sheet does not portray the market value of the entity as a going concern nor its liquidation value.
    • Resources such as employee skills and reputation are not recorded in the balance sheet.
    • Usefulness:
    • The balance sheet describes many of the resources a company has for generating future cash flows .
    • It provides liquidity information useful in assessing a company’s ability to pay its current obligations.
    • It provides long-term solvency information relating to the riskiness of a company with regard to the amount of liabilities in its capital structure.
    Reports a company’s financial position on a particular date.
  • Classifications Resources (Assets) Claims against resources (Liabilities) Remaining claims accruing to owners (Shareholders’ Equity)
  • Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
  • Current Assets
    • Cash
    • Cash Equivalents
    • Short-term Investments
    • Receivables
    • Inventories
    • Prepaid Expenses
    Will be converted to cash or consumed within one year or the operating cycle, whichever is longer . Current Assets Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills.
  • Operating Cycle of a Typical Manufacturing Company Use cash to acquire raw materials Convert raw materials to finished product Deliver product to customer Collect cash from customer 1 2 3 4
  • Noncurrent Assets
    • Investments
    • Property, Plant, & Equipment
    • Intangible Assets
    • Other Assets
    Not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer. Noncurrent Assets
  • Noncurrent Assets
    • Other Assets
    • Include long-term prepaid expenses and any noncurrent assets not falling in one of the other classifications.
    • Investments
    • Not used in the operations of the business.
    • Include both debt and equity securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes.
    • Property, Plant, and Equipment
    • Are tangible, long-lived, and used in the operations of the business.
    • Include land, buildings, equipment, machinery, and furniture as well as natural resources such as mineral mines, timber tracts, and oil wells.
    • Reported at original cost less accumulated depreciation (or depletion for natural resources).
    • Intangible Assets
    • Used in the operations of the business but have no physical substance.
    • Include patents, copyrights, and franchises.
    • Reported net of accumulated amortization.
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  • Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities as a result of past transactions or events.
  • Current Liabilities
    • Accounts Payable
    • Notes Payable
    • Accrued Liabilities
    • Unearned Revenues
    • Current Maturities of Long-Term Debt
    Obligations expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer. Current Liabilities
  • Long-term Liabilities
    • Long-term Notes
    • Mortgages
    • Long-term Bonds
    • Pension Obligations
    • Lease Obligations
    Obligations that will not be satisfied within one year or operating cycle, whichever is longer. Long-Term Liabilities
  • Shareholders’ equity is the residual interest in the assets of an entity that remains after deducting liabilities.
  • Management Discussion and Analysis Provides a biased but informed perspective of a company’s operations, liquidity, and capital resources.
  • Management’s Responsibilities
    • Preparing the financial statements and other information in the annual report.
    • Maintaining and assessing the company’s internal control procedures.
  • Auditors’ Report Expresses the auditors’ opinion as to the fairness of presentation of the financial statements in conformity with generally accepted accounting principles. Auditors’ reports must comply with specifications of the Public Companies Accounting Oversight Board (PCAOB).
  • Auditors’ Opinions Unqualified Issued when the financial statements present fairly the financial position, results of operations, and cash flows are in conformity with GAAP. Qualified Issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole. Adverse Issued when the exceptions are so serious that a qualified opinion is not justified. Disclaimer Issued when insufficient information has been gathered to express an opinion.
  • End of Chapter 3