Structure of the Balance Sheet and Statement of Cash Flows Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 4

Learning objectives How balance sheet accounts are measured and classified. How balance sheet information is used. Balance sheet terminology and format outside the U.S. How notes aid your understanding of the firm’s accounting policies, subsequent events, and related-party transactions. How successive balance sheet and the income statement can be used to identify cash inflows and outflows. How the cash flow statements can be used to explain changes in successive balance sheets. The distinction between operating, investing, and financing sources and uses of cash. How changes in current asset and current liability accounts can be used to compute “cash flows from operations” from accrual earnings. Differences between IFRS and U.S. GAAP for certain items on the statement of cash flows. 4-2

Elements of the balance sheet How the money is invested Where the money came from ASSETS LIABILITIES EQUITY = + Probable future economic benefits Obtained from past transactions or events Probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services in the future as a result of past transactions or events The residual interest in net assets. 4-3

Balance sheet information Rates of return ROA and ROCE ASSETS Capital structure Debt/Equity ratio Helps Liquidity Cash conversion LIABILITIES + EQUITY assess Solvency Ability to pay debt Flexibility Operating and financial Balance Sheet 4-4

Balance sheet measurement conventions Historical cost ASSETS Current cost (fair value) Measurement LIABILITIES + EQUITY methods Net realizable value Discounted present value Balance Sheet 4-5

Balance sheet classification: Overview ASSETS LIABILITIES EQUITY = + Current assets Property, plant and equipment Investments Other assets Current liabilities Long-term debt Other liabilities Preferred and common stock Additional paid-in capital Retained earnings 4-6

Balance sheet classification: Current assets Amortized cost or current market value Net realizable value Lower or (historical) cost or current market value 4-7

Balance sheet classification: Other assets Historical cost minus accumulated depreciation except that fair market value is used when “impaired” 4-8

Balance sheet classification: Liabilities Amount due at maturity Historical cost Discounted present value 4-9

Balance sheet classification: Stockholders’ equity Historical par value Historical cost Combination of different measurement bases 4-10

Analytical insights: Understanding the business Which company is? Deere E-Trade Potomac Electric Power Wal-Mart Analytical insights: Understanding the business 4-11

Balance sheet presentation: International differences U.S. Format: U.K. Format: Current Assets Fixed Assets + + Long-lived Assets Current Assets - = Non-current Liabilities Current Liabilities - + Current Liabilities Non-current Liabilities = + Stockholders’ Equity Capital Employed 4-12

Notes to Financial statements Notes are an integral part of companies’ financial reports. Help users better understand and interpret the numbers presented in the body of the financial statements. Three important notes: Summary of significant accounting policies. Subsequent event disclosures. Related-party transactions 4-13

Statement of cash flows Explains why a firm’s cash position changed between successive balance sheet dates. Here’s the balance sheet equation: Assets = Liabilities + Stockholders’ equity Cash Non-cash assets Stockholders’ equity Liabilities + = Cash Non-cash assets Liabilities = + - Stockholder’s equity ΔCash Δ Stockholders’ equity = + At the same time, it explains why non-cash assets, liabilities, and stockholders’ equity have changed. Δ Non-cash assets Δ Liabilities - 4-14

Cash flow statement format Cash inflows and outflows from transactions and events that affect operating income Operating Activities Cash inflows and outflows from loaning money to others, investing in securities, or in assets (e.g., equipment) used to produce goods and services. Investing Activities Cash inflows and outflows from borrowing money, selling stock, and paying dividends Financing Activities Δ Cash 4-15

Cash flow statement: Wal-Mart example Adjustments to accrual earnings 4-16

Cash flow statement: Wal-Mart example 4-17

Cash flow versus accrual earnings: HRB Advertising Company Opened for business on April 1, 2014. Transactions for the year include: Herb Wilson, Robin Hansen and Barbara Reynolds each contributed $3,500 cash on April 1 for shares of the company’s common stock. HRB rented office space beginning April 1 and paid the full year’s rental of $2,000 per month, or $24,000 in advance. The company borrowed $10,000 from a bank on April 1. The principal plus accrued interest payable is payable January 1, 2015 with interest at a rate of 12% per year. HRB purchased office equipment with a five-year life for $15,000 cash on April 1. Salvage value is zero and the equipment is being depreciated using the straight-line method. HRB sold and billed customers for $65,000 of advertising services rendered between April 1 and December 31. Of this amount $20,000 was still uncollected by year end. By year-end, the company incurred and paid the following operating costs: (a) utilities, $650; (b) salaries, $36,250; and (c) supplies, $800 The company had accrued (unpaid) expenses at year-end as follows: (a) utilities, $75 (b) salaries, $2,400; and (c) interest, $900. Supplies purchase on account and unpaid at year-end amounted to $50. When supplies are purchased they are charged to an asset account Supplies inventory on hand at year-end amounted to $100. Annual depreciation on office equipment is $15,000/5 = $3,000. Because the equipment was acquired on April 1, the depreciation expense for 2014 is $3,000 x 9/12 = $2,250. Profit (accrual earnings) for the year was $3,725 but the checking account was overdrawn by $11,200 4-18

Here’s what happened at HRB 4-19

Deriving cash flows from operations: Indirect approach 4-20

HRB’s cash flow statement: Indirect approach 4-21

Deriving cash flow information: HRB one year later Bank loan refinanced Stock issued 4-22

Deriving cash flow information: HRB’s accrual earnings 4-23

Deriving cash flow information: HRB’s cash flows 4-24

Deriving cash flow information: Overview Income statement Beginning Balance sheet Ending Balance sheet Cash flow statement You can always derive any one financial statement from information available in the other three statements. 4-25

Deriving cash flow information: Cash collected from customers 4-26

Deriving cash flow information: Salaries paid 4-27

Deriving cash flow information: Rent paid 4-28

Deriving cash flow information: Utilities paid 4-29

Deriving cash flow information: Cash paid for supplies 4-30

Deriving cash flow information: Interest paid 4-31

Deriving cash flow information: Office equipment cash flows 4-32

Deriving cash flow information: Cash receipts and disbursements 4-33

Global Vantage Point IFRS (IAS 7) encourages, but does not require, entities to report cash flows from operating activities using the direct method. Why: believed to provide information that is not available under the indirect method Both FASB and IASB tabled a proposal to mandate the use of the direct method for reporting operating cash flows since most computer systems aren’t set up to efficiently process the requisite data Subtle differences between IFRS and U.S. GAAP: one is how to report cash interest from investments U.S. GAAP reports these as part of operating cash flows IAS 7 allows the option to report these as cash flows from investing activities 4-34

Global Vantage Point An example – EMC Corporation Direct Method 4-35

Global Vantage Point An example – EMC Corporation Indirect Method 4-36

Global Vantage Point An example – EMC Corporation 4-37

Summary The balance sheet shows the assets owned by a company at a given point in time, and how those assets are financed (debt vs. equity). Be alert for differences in balance sheet measurement bases, account titles, and statement format. Financial statement notes provide important information. The cash flow statement shows the change in cash for a given period, broken down into operating, investing, and financing activities. 4-38

Summary concluded Changes in certain balance sheet accounts help explain why operating cash flows differ from accrual income. Conversely, the cash flow statement helps to explain changes in balance sheet accounts Understanding the interrelationships between successive balance sheets and the statement of cash flows Understanding the basic differences between IFRS and U.S. GAAP as well as differences between the direct and indirect approach to presenting cash flows from operations 4-39