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Chapter 5 Page 1 of 21
Chapter 5: Balance Sheet and Statement of Cash Flow
Balance Sheet: Financial position of a firm at a particular point in time;
Provides information about the nature and amounts of investments in enterprise
resources, obligations to creditors, and the owners’ equity in net resources.
Helps predict amounts, timing, and uncertainty of future cash flows.
1) Usefulness of the Balance Sheet: The balance sheet is useful for analyzing a
company’s liquidity, solvency, and financial flexibility.
a Liquidity: How quickly assets can be converted into cash.
b Solvency: How easily a company can pay its debt.
c Financial Flexibility: Ability to alter amounts and timing of cash flows as
necessary.
2) Limitations of the Balance Sheet:
a
In other words, the Balance Sheet information is highly reliable but not
necessarily as relevant.
b
c
(e.g., employees’ knowledge and skill, customer base, research superiority, and
reputation.) Also, some company obligations are omitted (e.g., certain types of
lease arrangements.)
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3) Classification in the Balance Sheet:
a General:
i) Balance Sheet Classification: similar items are grouped together to arrive at
significant subtotals.
ii) Report individual items separately. Such detail allows users to better assess
the amounts, timing, and uncertainty of future cash flows. (For example, if a
user can see the individual amount of Accounts Receivable, he can estimate
the amount of cash to be received in the next year from current year A/R.) It
also helps in evaluating liquidity and financial flexibility, profitability, and
risk. (For example, a user can estimate liquidity by observing individual debt
amounts.)
iii) The three general classes of items included in the balance sheet are:
(1) Assets: Probable future economic benefits owned or controlled by the
entity. Assets include:
(a)
(b)
(c)
(d)
(e)
(2) Liabilities: Probable future sacrifices of economic benefit (results from
past transactions or events.) Liabilities include:
(a)
(b)
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(3) Equity: Residual interest (i.e., what is left over) in the assets of an entity
that remains after deducting its liabilities. Owners’ Equity includes:
(a)
(i)
(ii)
(b)
(c)
(d)
(e)
(Note: Items listed in each section above are not all-inclusive;
however, they are typical of almost all Balance Sheets.)
b Current Assets:
Some exceptions exist: Example: Investment in common stock is classified as
either a current asset or a non-current asset depending on management’s intent.
Investments in small holdings of common stocks or bonds that are going to be
held for a long period of time.
Operating Cycle:
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Current Assets are presented in the balance sheet _________________________.
Each section is presented below in the __________________________________.
(Note: These 5 items are not considered current assets if they are not expected to
be realized in one year or in the operating cycle, whichever is longer.)
i) Cash:
(1) Valuation:
(2) Must disclose any restrictions. Depending on the circumstances, restricted
cash may be in current assets or non-current assets. See Illustration 5-2 on
page 173.
ii) Short-Term Investments:
(1) Valuation:
(2) Investments in debt and equity securities are grouped into three separate
portfolios for valuation and reporting purposes.
(a) Held-to-maturity: Debt securities intended to be held to maturity
(e.g., hold a bond until it expires.) Classified as current or non-current
depending on the circumstances.
(b) Trading: Debt and equity securities expected to be sold in the near
future.
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(c) Available-for-sale: Debt and equity securities not classified as held-
to-maturity or trading securities. Classified as current or non-current
depending on the circumstances.
iii) Receivables:
(1) Valuation:
(2) Clearly identify any anticipated loss due to uncollectible accounts, the
amount and nature of any non-trade receivables, and any receivables
designated or pledged as collateral.
iv) Inventories:
(1) Valuation:
(2) Must disclose valuation basis (i.e., lower of cost or market LCM) and
pricing method (e.g., FIFO, LIFO, etc.) Also, the stage of completion of
manufactured inventories should be disclosed (i.e., Raw Materials, WIP,
and Finished Goods.) See Illustrations 5-7 on page 176.
v) Prepaid Expenses:
(1) Valuation:
(2) Expenditures already made for benefits (usually services) to be received
within one year or the operating cycle, whichever is longer.
(3) Include as current assets even though they do not technically meet the
definition of a current asset; never convert into cash or used to pay a
liability, just use up.
(4) Insurance and other prepayments for longer than one year are often
included in current assets even though part of the advance payment applies
to periods beyond one year or the current operating cycle. (Could also be
included in “other asset” section as deferred charge.)
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(5) Examples:
c Non-Current Assets:
i) Long-Term Investments: Investments held for many years. Not acquired
with the intention of selling in the near future.
(1) Investments normally consisting of one of four types:
(a) Investments in securities
Why hold these?
(b) Investments in tangible fixed assets not currently used in operations.
(c) Investments set aside in special funds such as
(d) Investments in non-consolidated subsidiaries or affiliated companies.
(2) Depending on managements’ intent, classified as either Available-for-Sale
or Held to Maturity.
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ii) Property, Plant, and Equipment: Tangible, long-term fixed assets acquired
for use in main operations. (In practice, a detailed classification of PPE is
disclosed in a supplementary schedule rather than on the face of the balance
sheet.)
(1) Land:
(2) Buildings, equipment, furniture, fixtures:
(If equipment is held for sale, include it separately in the current asset
section or include it in the investment section.)
(3) Natural Resources:
(4) Capitalized leases:
iii) Intangible Assets: IA have no physical substance but they convey value
because of ownership rights.
(1) Examples:
(a)
(b)
(c)
(d)
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(2) Reporting:
(a) Limited-life intangibles are written off (amortized using straight-line
method) over their useful lives.
(b) Indefinite-life intangibles (e.g., goodwill) are not amortized, but are
periodically assessed for impairment.
(c) Expenditures for intangible assets such as most R&D (Research and
Development) and internally-developed goodwill are not capitalized
but are expensed as incurred.)
iv) Other Assets:
(1) Examples: Deferred charges (long-term prepaid expenses), non-current
receivables, intangible assets, assets in special funds, deferred income
taxes.
(2) Section tends to be too general. It should be restricted to unusual items
sufficiently different from assets included in special categories.
v) Classification of Assets: Depends on the nature of item and the use of item.
For example:
(1) Land used as factory site –
(2) Land owned by a realty company and held for sale –
(3) Land held for speculation –
(4) Idle land and facilities that have been withdrawn from production –
d Liabilities:
i) Current Liabilities (CL):
(1) Obligations expected to be settled using current assets or creating current
liabilities.
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(2) Examples:
(a) Payables resulting from acquiring goods and services (e.g., accounts
payable, wages payable, taxes payable.)
(b) Unearned Revenue: Collections received in advance for delivery of
goods or performance of services.
(c) Other liabilities whose liquidation will take place within the operating
cycle (e.g., portion of long-term bonds payable in current year, short-
term obligations arising from equipment purchase.)
(3) Current Liabilities are not reported in a consistent order. However, they
are frequently reported in the order they will be paid.
(4) Some liabilities that will be paid within a year are reported as long-term
liabilities. These include:
(a) If debt is refinanced through another long-term debt issuance
(b) If debt is retired out of non-current assets.
(5) Working Capital:
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ii) Long-Term Liabilities:
(1) Obligations that are not reasonably expected to be liquidated within the
normal operating cycle.
(2) Examples:
(a) Obligations from Specific Financing:
(i)
(ii)
(iii)
(iv)
(b) Obligations from Ordinary Operations:
(i)
(ii)
(c) Obligations dependent on the occurrence and outcome of future
events:
(i)
(ii)
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(3) The currently maturing portion of long-term debt is classified as a current
liability.
(4) Supplementary Information Typically Disclosed: Debt
covenants/restrictions; maturity dates; interest rates; amount of securities
pledged to support debt.
e Owners’ Equity:
i) General:
(1) Contributed Capital (i.e., Capital Stock):
(a)
(b)
(c)
(d)
Can have APIC for Preferred Stock, Common Stock, Common Stock
Subscribed, and Treasury Stock. (These amounts can be presented as
one total sum or as individual amounts.)
(2) Retained Earnings: Accumulated earnings of the company over its life
less any dividends distributed to stockholders. This section may be
divided between unappropriated (amount available fore dividend
distribution) and any amounts that are restricted (e.g., bond indentures or
other loan agreements.)
(3) Accumulated Other Comprehensive Income: See Chapter 4. If amount
represents income (loss), it is an addition (subtraction).
Chapter 5 Page 12 of 21
(4) Treasury Stock
ii) Must disclose capital stock authorized, issued, and outstanding par value
amounts.
f Balance Sheet Format:
i) Account form: Lists assets by sections on the left side, and liabilities and
stockholders’ equity by sections on the right side.
ii) Report form: Lists liabilities and stockholders’ equity directly below assets
on the same page. (See Illustration 5-15 on page 182.)
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iii) Example following report form format:
Company Name
Balance Sheet
December 31, 20xx
Assets
Current Assets
Cash
Receivables
Inventory
Prepaid Expenses
Total current assets
Long-Term Investments
Available for sale securities
Property, plant, and equipment
Land – at cost
Buildings – at cost
Less: Accumulated depreciation
Equipment – at cost
Less: Accumulated depreciation
Total property, plant, and equipment
Intangible assets
Goodwill
Total assets
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Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable
Notes payable
Income taxes payable
Accrued liabilities
Total current liabilities
Long-term Liabilities
Bonds Payable
Long Term Debt
Deferred income taxes
Total liabilities
Stockholders’ equity
Preferred Stock
Common Stock
APIC
Retained Earnings
Accumulated other comprehensive income
Total stockholders’ equity
Total liabilities and stockholders’ equity
Chapter 5 Page 15 of 21
g Altman’s “Z-score”: This is a bankruptcy-prediction model that can be used to
help evaluate the overall financial position and trends of a firm.
WorkingCapital Re tainedEarnings EBIT
Z 1.2 1.4 3.3
TotalAssets TotalAssets TotalAssets
Sales MVEquity
0.99 ).6
TotalAssets TotalLiabilities
Companies with z-scores above 3.0 are unlikely to fail. Companies with z-scores
below 1.81 are very likely to fail.
(I doubt that I will test you on this but you should be aware of this model when
you are practicing accounting.)
4) Additional Information Reported:
a Contingencies: Material events that have an uncertain outcome. (Examples:
Uncertain gains/losses from litigation; uncertain gains/losses from environmental
issues; uncertain gains/losses from on-going governmental investigations.)
Include as Long Term Liability if loss is probable and estimable.
b Accounting Policies:
i) Describe all significant accounting principles and methods that involve
selection from among alternatives and/or those that are peculiar to a given
industry.
ii) Disclose information about nature of operations, use of estimates in preparing
financial statements, certain significant estimates, and vulnerabilities due to
certain concentrations. (That is, disclose information about risks and
uncertainties involved in operations.)
iii) This information is typically given in a “Summary of Significant Accounting
Policies.” This note either precedes the footnotes or is the first footnote. (I
have always seen this as the first footnote.) See Procter & Gamble example,
Note 1, page 211 to 213.
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c Contractual Situations: Significant contractual situations should be disclosed in
financial statement notes.
i) It is MANDATORY to disclose provisions of lease contracts, pension
obligations, and stock option plans in the notes.
ii) Commitments related to obligations to maintain working capital, to limit the
payment of dividends, to restrict the use of assets, and to require the
maintenance of certain financial ratios must all be disclosed if material.
iii)
d Fair Values: Financial Instruments: Cash, an ownership interest, or a
contractual right to receive or obligation to deliver cash or another financial
instrument.
i) Can be either assets or liabilities:
ii) Both carrying value and estimated fair value of financial instruments must be
disclosed. (See Illustration 5-18 on page 187.)
5) Techniques of Disclosure:
a Parenthetical Explanations:
b Notes:
c Cross Reference and Contra Items:
Remember, a contra account on a balance sheet is
An adjunct account
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d Supporting Schedules:
e Terminology: Use of the term “surplus” is discouraged. The term “reserve”
should be used only to describe an appropriation of retained earnings.
6) Purpose of the Statement of Cash Flows:
a Remember that “assessing the amounts, timing, and uncertainty of cash flows”
was presented as one of the three basic objectives of financial reporting in
Chapter 2. The Statement of Cash Flow helps meet this objective. It is a required
statement.
b Purposes of Statement:
i) Primary Purpose:
ii) To summarize the operating, investing, and financing activities of the
business.
c Reporting sources, uses, and net increase/decrease in cash helps investors,
creditors, and others know what is happening to a company’s most liquid
resource. This statement provides answers to the following questions:
i)
ii)
iii)
Chapter 5 Page 18 of 21
d Helps evaluate liquidity, solvency, and financial flexibility.
i) Liquidity:
ii) Solvency:
iii) Financial Flexibility:
7) Content and Format of the Statement of Cash Flows:
Cash receipts and cash payments during a period are classified in the statement of
cash flows into three different activities – operating, investing, and financing
activities.
a Operating activities:
b Investing activities:
Specific Examples:
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c Financing activities:
Specific Examples:
d Basic Format: Illustration 5-24, page 192
HEADING
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Net increase (decrease) in cash
Cash at beginning of year
Cash at end of year
8) Preparation of the Statement of Cash Flows:
a Info needed to prepare CF Stmt comes from:
i)
ii)
iii)
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b In preparing CF Stmt, one must:
i) Determine cash provided by operations.
ii) Determine cash provided by/used in investing and financing activities.
iii) Determine change in cash during period.
iv) Reconcile change in cash with beginning and ending cash balances.
c Cash from Operations: The excess of cash receipts over cash payments.
Determined by converting net income on an accrual basis to a cash basis. This is
accomplished by adding to or deducting from net income those items in the
income statement not affecting cash. This procedure requires an analysis not only
of the current year’s income statement but also of the comparative balance sheets
and selected transaction data.
Formula:
d See Illustration 5-30, Comprehensive Statement of Cash Flows on page 195.
e Significant non-cash transactions:
i) All significant financing and investing activities must be disclosed in the CF
statement or notes, even though cash is not affected.
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ii) Examples:
(1)
(2)
9) Usefulness of the Statement of Cash Flows:
For small and newly developing companies, cash flow is the single most important
element for survival. Even medium and large companies indicate a major concern in
controlling cash flow.
Companies can fail even tough they are profitable. Net income and net cash provided
by operating activities can be substantially different.
The reasons for the difference between a positive net income and a negative net cash
provided by operating activities are substantial increases in receivables and/or
inventories.
a Financial Liquidity:
b Financial Flexibility:
c Free Cash Flow:
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