Chapter 2- The Balance Sheet.pptx

Chapter 2
The Balance Sheet
2-1

Copyright © 2016 Pearson Education, Ltd.
The Balance Sheet
• Also called the statement of condition
or the statement of financial position.
• Shows the financial condition of a
company on a particular date
• Summarizes what the firm owns
(assets) and what the firm owes to
outsiders (liabilities) and to internal
owners (stockholders’ equity).
2-2

Financial Condition
• Assets are what the firm owns.
• Liabilities are what the firm owes
to outsiders.
• Stockholders’ equity is what the
firm owes to internal owners.
equity
rs'
Stockholde
s
Liabilitie
Assets 

2-3

Financial Condition
2-4

Financial Condition
• Consolidation:
 Parent company owns more
than 50% of voting stock.
 Financial statements are
combined.
2-5

Financial Condition
• Balance Sheet Date
 The date the balance sheet is prepared
 Could be the end of the calendar year,
fiscal year, quarter, etc.
2-6

Financial Condition
• Comparative Data
 SEC requires two-year audited balance
sheets and three-year audited
statements of income and cash flows.
 Provides a reference point for
determining changes in financial
position
2-7

Financial Condition
• Balance Sheet Format:
 Not prescribed by the FASB, SEC, or IASB
 Majority of firms prepare classified
balance sheets.
 Differences in order of assets and
liabilities
2-8

Financial Condition
Common-Size Balance Sheet
• Expresses each item on the balance sheet as a
percentage of total assets
• Reveals the composition of assets within
major categories.
• Is a form of vertical ratio analysis
• Is useful for evaluating trends within a firm
• Allows for making industry comparisons
2-9

Financial Condition
2-10

Assets
• Segregated according to how they
are utilized
 Current Assets
 Property, Plant, and Equipment
 Other Assets
2-11

Assets
• Current Assets
 Continually used up and replenished
 Expected to be converted to cash
within one year or one operating cycle,
whichever is longer.
2-12

Assets
• Current Assets
 Operating cycle
• Time required to purchase or manufacture
inventory, sell the product, and collect the
cash
 Working capital
• Also called net working capital
• Current assets less current liabilities
2-13

Assets
Current Assets
• Cash and cash equivalents
• Marketable securities
• Accounts receivable
• Inventories
• Prepaid expenses
2-14

Assets
2-15

Assets
• Current Assets – Cash and Cash
Equivalents:
 Cash awaiting deposit
 Cash in a bank account
 Short-term investments that can be
converted to cash within three months
2-16

Assets
• Current Assets – Marketable
Securities
 Short-term investments that can be
converted to cash within a year
 Three categories
• Held to maturity
• Trading securities
• Securities available for sale
2-17

Assets
• Current Assets – Accounts
Receivable:
 Are customer balances outstanding on credit
sales
 Reported at net realizable value – actual
amount of account less an allowance for
doubtful accounts
2-18

Assets
Receivable
 Allowance for doubtful accounts
• Affects balance sheet valuation
• Important in assessing earnings quality
• Should reflect volume of credit sales, past
experiences with customers, customer base,
credit policies, collections practices, economic
conditions, and changes in any of these.
2-19

Assets
• The allowance account for Sage Inc.
represents approximately 5% of accounts
receivable:
2-20

Assets
Receivable
 There should be a consistent
relationship between the rate of change
in sales, accounts receivable, and the
allowance for doubtful accounts.
2-21

Assets
Sage Inc.
2-22

Assets
To analyze the preceding information, consider
the following:
• Are all three accounts changing in the same
directions and at consistent rates of change?
• If the direction and rates of change are not
consistent, what are possible explanations for
these differences?
• If there is not a normal relationship between
the growth rates, what are possible reasons
for the abnormal pattern?
2-23

Assets
• For Sage Inc.,
 Sales, accounts receivable, and the allowance
for doubtful accounts have all increased.
 Allowance account has increased
appropriately in relation to accounts
receivable.
 Sales have grown at a much greater rate.
• More sales in cash have probably been collected.
• Sage will probably experience fewer defaults.
2-24

Assets
• Current Assets – Accounts Receivable
 Additional information helpful to the
analysis of accounts receivable and the
allowance account is provided in the
schedule of “Valuation and Qualifying
Accounts.” required by the SEC in the
form 10-K.
• Additions Charged to Costs and Expenses
• Deductions
2-25

Assets
2-26
Sage’s Inc. schedule from the Form 10-K

Assets
• “Additions Charged to Costs and Expenses” is
the amount estimated and recorded as bad debt
expense each year on the income statement.
• “Deductions” is the actual amount the firm has
written off as accounts receivable they no longer
expect to recover.
• Analyst should use this schedule to assess the
probability that the firm is intentionally over- or
underestimating the allowance account.
• Sage Inc. appears to estimate an expense fairly
close to the actual amount written of each year.
2-27

Assets
• Current Assets – Inventories
 Items held for sale
 Items used in the manufacture of
products that will be sold
 Major revenue producer for most
companies
2-28

Assets
Current Assets – Inventories
• Retail companies
 Finished goods
• Manufacturing companies
 Raw materials
 Work-in-process
 Finished goods
• Service–oriented companies
 Little to no inventory
2-29

Assets
2-30

Assets
Current Assets – Inventories
• Inventory Accounting Methods:
 Method used has considerable impact on financial
position and operating results.
 Valuation is based on an assumption regarding
the flow of goods, not the actual order in which
products are sold.
 Cost flow assumption is made in order to match
the cost of products sold to the revenue generated.
 Disclosure of inventory cost flow assumption is
found in the notes.
2-31

Assets
 Inventory Accounting Methods:
• First in, first out (FIFO)
• Last in, first out (LIFO)
• Average cost
2-32

Assets
Example – A new company in its first
year of operations purchases five products
for sale in the order and at the prices
shown. The company sells three of these
items at the end of the year.
Unit Cost Per Unit
#1 $5
#2 $7
#3 $8
#4 $9
#5 $11
2-33

Assets
Cost flow assumptions
Resulting effect on the income statement and
balance sheet
2-34

Assets
 Inventory Accounting Methods:
 During a period of inflation, the LIFO
method typically produces
• the highest cost of goods sold expense
• the lowest ending valuation of inventory
• undervalued inventories on the balance sheet
• cost of goods sold values at current cost of
inventory items
2-35

Assets
• Inventory Accounting Methods:
 During a period of inflation, the FIFO
method typically produces
• the lowest cost of goods sold expense
• the highest ending valuation of inventory
• inventory values on the balance sheet that are
at current cost
• cost of goods sold values below the current
cost of inventory items
2-36

Assets
2-37

Assets
• Current Assets – Prepaid Expenses
 Expenses paid in advance
• Insurance
• Rent
• Property taxes
• Utilities
• Included in current assets if they expire within
one year or one operating cycle
• Generally not material to the balance sheet
2-38

Assets
• Property, Plant, and Equipment
(PP&E)
 Encompasses a company’s fixed assets
 Not used up during annual operations
 Produce economic benefits for more than one
year
 Have physical substance
 Shown at book value on the balance sheet
2-39

Assets
Property, Plant, and Equipment (PP&E)
• The relative proportion of fixed assets in a
company’s asset structure will largely be
determined by the nature of the business.
• Manufacturing firms typically have higher
percentages of fixed assets than retailers or
wholesalers.
• Firms with newly purchased assets will have
higher percentages of fixed assets than firms
with older fixed assets.
2-40

Assets
• PP&E – Depreciation
 Fixed assets (with the exception of land)
are depreciated over the period of time
they benefit the firm.
 Method of allocating the cost of long-lived
assets
 Original cost less estimated residual value
is spread over the asset’s expected life.
2-41

Assets
• PP&E – Depreciation Methods
 Straight-line method allocates an equal
amount of expense to each year of the
depreciation period.
 Accelerated methods apportion larger
amounts of expense to earlier years of the
asset’s depreciable life.
 Units-of-production method bases
depreciation expense on actual use.
2-42

Assets
Example – Assume that Sage Inc. purchases
an artificial ski mountain for its Phoenix flagship
store in order to demonstrate skis and allow
prospective customers to test-run skis on a
simulated course. The cost of the mountain is
$50,000 and is expected to have a five-year
useful life and $0 salvage value at the end of that
period.
Compute the depreciation expense using the
straightline and the accelerated methods (double-
declining balance method).
2-43

Assets
2-44

Assets
2-45

Assets
• Property, Plant, and Equipment
(PP&E)
 Land
 Buildings
 Leasehold improvements
 Construction in progress
 Equipment
2-46

Assets
• PP&E – Land
 Property used in business
 Not investment property
2-47

Assets
• PP&E – Buildings
 Buildings owned by the company
• Stores
• Corporate offices
2-48

Assets
• PP&E – Leasehold Investments
 Additions made to leased structures
 Improvements made to leased structures
 Revert to the property owner when the
lease expires
 Amortized by the lessee over the economic
life of the improvement (or the life of the
lease)
2-49

Assets
• PP&E – Construction in Progress
 Costs of constructing new buildings
that are not yet complete.
2-50

Assets
• PP&E – Equipment
 Original cost of machinery and
equipment used in business operations.
2-51

Assets
2-52

Assets
• Goodwill
 Arises when one company acquires
another company for a price in excess of
the fair market value of the net
identifiable assets acquired
 Evaluated annually
• If no loss of value has occurred, goodwill
remains on the balance sheet.
• If the book value exceeds the fair value, the
excess must be written off as an impairment
expense.
2-53

Assets
• Other Assets
 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)
2-54

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
2-55

Liabilities
• Current Liabilities
 Accounts payable
 Notes payable
 Current portion of long-term debt
 Accrued liabilities
 Unearned revenue
2-56

Liabilities
• Accounts Payable
 Short-term obligations that arise from
credit extended by suppliers for the
purchase of goods and services
 Eliminated when the bill is satisfied
 Increase and decrease depending on credit
policies, economic conditions, and cyclical
nature of operations
2-57

Liabilities
2-58

Liabilities
• Short-Term Debt
 Also referred to as notes payable
 Short-term obligations in the form of
promissory notes
 Lines of credit to suppliers or financial
institutions
2-59

Liabilities
• Current Maturities of Long-term
Debt
 Portion of the principal of long-term
debt that will be repaid during the
upcoming year
2-60

Liabilities
• Accrued Liabilities
 Result from recognition of an expense
prior to actual payment of cash
 Reserve accounts
• Set up for the purpose of estimating
obligations for items such as warranty costs,
sales returns, or restructuring charges
• Identified in the notes to the financial
statements
2-61

Liabilities
Example – Assume that a company has a
$100,000 note outstanding with 12% interest due
in semiannual installments on March 31 and
September 30. For a balance sheet prepared on
December 31, interest will be accrued for three
months (October, November, and December). The
December 31 balance sheet would include an
accrued liability of $3,000:
$100,000 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
2-62

Liabilities
• Unearned Revenue or Deferred
Credits
 Result from payments received in advance for
services and products
 Transferred to a revenue account when the
service is performed or the product is
delivered
2-63

Liabilities
• Deferred Federal Income Taxes
 Result of temporary differences in the
recognition of revenue and expense for
taxable income relative to reported
income
 Depreciation methods are the most
common source for temporary differences.
2-64

Liabilities
 Other sources of temporary differences
arise from the methods used to account
for:
• Installment sales
• Long-term contracts and leases
• Warranties and service contracts
• Pensions and other employee benefits
• Subsidiary investment earnings
2-65

Liabilities
 Permanent differences in income tax
accounting do not affect deferred taxes.
• Municipal bond revenue
• Life insurance premiums
2-66

Liabilities
 Valuation allowance
• Used to reduce deferred tax assets to
expected realizable amounts
• Used when it is more likely than not that
some of the deferred tax assets will not be
realized
2-67

Liabilities
Example – Assume that a company has a total
annual revenue of $500,000, expenses other
than depreciation of $250,000, and a
depreciation expense of $100,000 for tax
accounting and $50,000 for financial reporting.
The income for tax reporting purposes would be
computed two ways, assuming a 34% tax rate:
2-68

Liabilities
Taxes actually paid ($51,000) are less than
the tax expense ($68,000) reported in the
financial statements. To reconcile the
$17,000 difference between the expense
recorded and the cash outflow, there is a
deferred tax liability of $17,000:
2-69

Liabilities
2-70

Liabilities
 Deferred taxes are not always classified
as current liabilities.
 They may also appear on the balance
sheet as a current asset, a noncurrent
asset, or a noncurrent liability.
2-71

Liabilities
Long-term Debt
• Long-term notes payable
• Mortgage
• Debentures
• Bonds payable
• Convertible debt
• Long-term warranties
2-72

Liabilities
• A capital Lease meets any one of the
following four criteria:
 Transfers ownership to the lessee
 Contains a bargain purchase option
 Has a lease term of 75% or more of the leased
property’s economic life
 Has minimum lease payments with a present
value of 90% or more of the property’s fair
value
2-73

Liabilities
• Capital Lease Obligations
 A “purchase” rather than a “lease”
 Affect both balance sheet and income
statement
 Disclosures found in the notes, often
under both the PP&E note and the
commitments and contingencies note
2-74

Liabilities
• Pensions and Postretirement Benefits
 Pensions are cash compensation paid to
retired employees.
 Postretirement benefits are benefits other
than pensions that employers promise to
pay for retired employees.
 Can appear under the liability section of the
balance sheet
2-75

Liabilities
• Commitments and Contingencies
 Commitments refer to contractual
agreements that will have a significant
financial impact in the future.
 Contingencies refer to potential liabilities
(such as possible damage awards assessed in
lawsuits).
2-76

Stockholders’ Equity
• Also called shareholders’ equity
• Residual interest in assets that remains
after deducting liabilities
• Owners bear greatest risk and benefit
from greatest rewards.
2-77

• Common Stock
 Shareholders
• do not ordinarily receive a fixed return
• have voting privileges in proportion to
ownership interest
• can benefit through price appreciation
• can suffer through price depreciation
2-78

• Common Stock
• Dividends are declared at the discretion of
a company’s board of directors
• Amount listed on the balance sheet is
based on the par or stated value of the
shares issued (which bears no relationship
to actual market price).
2-79

• Additional Paid-In Capital
 Reflects the amount by which the
original sales price of the stock shares
exceeded par value
2-80

• Retained Earnings
 Sum of every dollar a company has earned
since inception less any payments made to
shareholders
 Funds a company has elected to reinvest
in the operations of the business rather
than pay out in dividends
 Measurement of all undistributed earnings
2-81

• Retained Earnings
 Key link between the income
statement and the balance sheet
 Unless there are unusual transactions
affecting the retained earnings
account,
Beginning
retained
earnings
Net
income
(loss)
Ending
retained
earnings
– Dividends =
±
2-82

• Other Equity Accounts
 Preferred stock
 Accumulated other comprehensive
income (expense)
 Treasury stock
 Equity attributable to noncontrolling
interests
2-83

2-84

• Other Equity Accounts – Preferred Stock
 Carries a fixed annual dividend payment
 Carries no voting rights
2-85

• Other Equity Accounts – Accumulated
Other Comprehensive Income (Expense)
 Unrealized gains or losses in the market value of
investments in available-for-sale securities
 Any change in the excess of additional pension liability
over unrecognized prior service cost.
 Certain gains and losses on derivative financial
instruments
 Foreign currency translation adjustments resulting
from converting financial statements from a foreign
currency into U.S. dollars
2-86

• Other Equity Accounts – Treasury Stock
 Repurchased shares of stock that are not retired
 Shown as an offsetting account
2-87

• Other Equity Accounts – Equity
Attributable to Noncontrolling Interests
 Represents the equity interest a firm has in
companies whose financial statement have
been consolidated with the firm’s statements
but that are not 100% owned by the firm.
2-88

Quality of Financial Reporting
• Economic recession of 2008 and many market
gyrations since can be traced directly to
overvaluation of balance sheet assets.
• When financial reporting does not reflect
economic reality, quality and usefulness of
information are significantly impaired.
• Type of debt used to finance assets,
commitments and contingencies, and the
classification of leases relate directly to quality
of financial reporting.
2-89

Quality of Financial Reporting
• “Commitments and Contingencies”
disclosure in the notes to financial
statements provide important information
about off-balance sheet financing and other
complex financing arrangements.
• Enron is a prime example of a company
with enormous activity reported in the
“Commitments and Contingencies”
disclosure.
2-90

Other Balance Sheet Items
• Corporate balance sheets are not
limited to the accounts described in
this chapter.
• The reader of annual reports will
encounter additional accounts and
will find many of the same accounts
listed under different titles.
2-91

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