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Chap003 jpm-f2011
 

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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.
  • 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.
  • There are more similarities than differences in balance sheets prepared according to U.S. GAAP and those prepared applying IFRS. Some of the differences include: International standards specify a minimum list of items to be presented in the balance sheet. U.S. GAAP has no minimum requirements. IAS No. 1, revised, changed the title of the balance sheet to statement of financial position, although companies are not required to use that title. Some U.S. companies use the statement of financial position title as well. Under U.S. GAAP, we present current assets and liabilities before noncurrent assets and liabilities. IAS No. 1 doesn’t prescribe the format of the balance sheet, but balance sheets prepared using IFRS often report noncurrent items first.
  • This slide illustrates the asset section of the British Airways balance sheet at March 31, 2009. Notice that their balance sheet starts with non-current assets followed by current assets. Also notice that the current assets end with the cash account rather than begin with the cash account.
  • The equity and liability section of the British Airways Balance Sheet at March 31, 2009 are illustrated on this slide. Notice that in this format the equity section is presented first and that non-current liabilities are presented before current liabilities.
  • The FASB and IASB are working together on a project, Financial Statement Presentation, to establish a common standard for presenting information in the financial statements, including classifying and displaying line items and aggregating line items into subtotals and totals. This standard will have a dramatic impact on the format of financial statements. An important part of the proposal involves the organization of elements of the balance sheet (statement of financial position), statement of comprehensive income (including the income statement), and statement of cash flows into a common set of classifications. Each of the financial statements will include classifications by operating, investing, and financing activities, providing a “cohesive” financial picture that stresses the relationship among the financial statements. Recall that this is the way we currently classify activities in the statement of cash flows. For each statement, though, operating and investing activities will be included within a new category, “business” activities. Each statement also will include three additional groupings: discontinued operations, income taxes, and equity (if needed). The new look for the balance sheet will be similar to the format seen on this slide.
  • Part I The full-disclosure principle requires that financial statements provide all material, relevant information concerning the reporting entity. Disclosure notes typically span several pages and either explain or elaborate upon the data presented in the financial statements themselves, or provide information not directly related to any specific item in the statements. Disclosure notes must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions. The summary of significant accounting policies conveys valuable information about the company’s choices from among various alternative accounting methods. For example, management chooses whether to use accelerated or straight-line depreciation and whether to use first-in, first-out; last-in, first-out; or weighted average to measure inventories. Typically, this first disclosure note consists of a summary of significant accounting polices that discloses the choices the company makes. Part II A subsequent event is a significant development that occurs after the company’s fiscal year-end but before the financial statements are issued or available to be issued. Examples include the issuance of debt or equity securities, a business combination or the sale of a business, the sale of assets, an event that sheds light on the outcome of a loss contingency, or any other event having a material effect on operations. Part III Some transactions and events occur only occasionally, but when they do occur are potentially important to evaluating a company’s financial statements. In this category are related party transactions, errors and irregularities, and illegal acts.
  • 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.
  • Liquidity refers to the readiness of assets to be converted to cash. Liquidity ratios compare a company’s obligations that will shortly become due with the company’s cash and other current assets that, by definition, are expected to be used to pay for the obligations that will be due in the short term. The current ratio is calculated as current assets divided by current liabilities and measures a company’s ability to satisfy its short-term liabilities. A current ratio of 2 indicates that the company has twice as many current assets available as current liabilities. A company could have difficulty paying its liabilities even with a current ratio significantly greater than 1.0. For example, a large portion of the current assets could include inventory. If the inventory is not able to be converted into cash for several months, obligations may come due that could not be paid out of current assets. The acid-test ratio is calculated as quick assets divided by current liabilities. Quick assets are current assets excluding inventories and prepaid items. By eliminating current assets less readily convertible into cash, this ratio provides a more stringent indication of a company’s ability to pay its current liabilities.
  • Investors and creditors, particularly long-term creditors, are vitally interested in a company’s long-term solvency and stability. The debt to equity ratio is calculated as total liabilities divided by shareholders’ equity. This ratio indicates the extent of reliance on creditors, rather than owners, in providing resources. The higher this ratio, the greater the creditor claims on assets, so the higher the likelihood an individual creditor would not be paid in full if the company is unable to meet its obligations. The times interest earned ratio is a way to gauge the ability of a company to satisfy its fixed debt obligations by comparing interest charges with the income available to pay those charges. This ratio is calculated as net income plus interest expense plus income taxes divided by interest expense. The times interest earned ratio indicates the margin of safety provided to creditors.
  • Appendix 3: Reporting by Operating Segment Many companies operate in several business segments as a strategy to achieve growth and to reduce operating risk through diversification. Segment reporting facilitates the financial statement analysis of diversified companies. The following characteristics define an operating segment. An operating segment is a component of an enterprise: That engages in business activities from which it may earn revenues and incur expenses. Whose operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance. For which discrete financial information is available.
  • GAAP requires an enterprise to report certain geographic information unless it is impracticable to do so. This information includes revenues from external customers attributed to the enterprise’s country of domicile and attributed to all foreign countries in total from which the enterprise derives revenues, and long-lived assets other than financial instruments, long-term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets located in the enterprise’s country of domicile and located in all foreign countries in total in which the enterprise holds assets. Revenues from major customers must also be disclosed. If ten percent or more of the revenue of an enterprise is derived from transactions with a single customer, the enterprise must disclose that fact, the total amount of revenue from each such customer, and the identity of the operating segment or segments earning the revenue. This information provides insight concerning the extent to which a company’s prosperity depends on one or more major customers.
  • End of Chapter 3.

Chap003 jpm-f2011 Chap003 jpm-f2011 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 (pages 116-118)
    • 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 (page 117) 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 (page 119)
    • Other Assets
    • Include long-term prepaid expenses and any noncurrent assets not falling in one of the other classifications .
    • Investments
    • Not used in business operations
    • 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 business operations
    • 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 business operations - have no physical substance (rights to …)
    • Include patents, copyrights, and franchises.
    • Reported net of accumulated amortization.
    ©
  • 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 (page 120)
    • 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 (page 121)
    • 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.
  • U. S. GAAP vs. IFRS (page 122)
    • Does not specify a minimum list of items to be presented in the balance sheet.
    • Some U.S. companies use the title :Statement of financial position”
    • Presents current assets and liabilities before noncurrent assets and liabilities.
    • Specifies a minimum list of items to be presented in the balance sheet.
    • Statement title = Statement of financial position.
    • Does not prescribe the format of the balance sheet, but balance sheets prepared using IFRS often report noncurrent items first.
    There are more similarities than differences in balance sheets prepared according to U.S. GAAP and those prepared applying IFRS.
  • British Airways Balance Sheet At March 31, 2009
  • British Airways Balance Sheet At March 31, 2009
  • U. S. GAAP vs. IFRS The FASB and IASB are working together on the Financial Statement Presentation project to establish a common standard for presenting information in the financial statements. Each of the financial statements will include classifications by operating, investing, and financing activities, as well as income taxes, discontinued operations, and equity (if needed).
  • Disclosure Notes (pages 125-127) Summary of Significant Accounting Policies Conveys valuable information about the company’s choices from among various alternative accounting methods. Subsequent Events A significant development that occurs after the company’s fiscal year-end but before the financial statements are issued or available to be issued. Noteworthy Events and Transactions Transactions or events that are potentially important to evaluating a company’s financial statements, e.g., related parties, errors and irregularities, and illegal acts.
  • Management’s Responsibilities (pages 128-129)
    • Preparing the financial statements and other information in the annual report.
    • Maintaining and assessing the company’s internal control procedures.
  • Auditors’ Report (pages 129-130) 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 .
  • Liquidity Ratios (pages 133-134) = Current ratio Current assets Current liabilities Measures a company’s ability to satisfy its short-term liabilities = Acid-test ratio Quick assets Current liabilities Provides a more stringent indication of a company’s ability to pay its current liabilities
  • Financing Ratios (page 135) = Debt to equity ratio Total liabilities Shareholders’ equity Indicates the extent of reliance on creditors, rather than owners, in providing resources = Times interest earned ratio Net income + Interest expense + Income taxes Interest expense Indicates the margin of safety provided to creditors
  • Appendix 3: Reporting by Operating Segment Reportable Operating Segment Characteristics Engages in business activities from which it may earn revenues and incur expenses. Operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance. Discrete financial information is available.
  • Segment Reporting (pages 140-142) Reporting by Geographic Area GAAP requires an enterprise to report certain geographic information unless it is impracticable to do so. Information About Major Customers Revenues from customers generating 10% or more of the revenue of an enterprise must be disclosed.
  • End of Chapter 3