C 3 hapter The Balance Sheet and the Statement of Changes in Stockholders’ Equity An electronic presentation by Douglas Cloud Pepperdine University 1 1 1 1

Objectives 1. Understand the purposes of the balance sheet. 2. Define the elements of a balance sheet. 3. Explain how to measure the elements of a balance sheet. 4. Classify the assets of a balance sheet. 5. Classify the liabilities of a balance sheet. 6. Report the stockholders’ equity of a balance sheet. Continued 2 2 2 4

Objectives 7. Prepare a statement of changes in stockholders’ equity. 8. Understand the other disclosure issues for a balance sheet. 9. Describe the SEC integrated disclosures. 10. Explain the reporting techniques used in an annual report.

FASB Statement of Concepts No. 5 FASB Statement of Concepts No. 5 recommends that a full set of financial statements for an accounting period should show a company’s...

FASB Statement of Concepts No. 5 (1) Financial position at the end of the period. (2) Net income for the period. (3) Comprehensive income for the period. (4) Cash flows for the period. (5) Investments by and distributions to owners for the period.

Interrelationship of Financial Statements Beginning Balance Sheet Assets Liabilities Stockholders’ Equity Transactions and Events Continued

Interrelationship of Financial Statements Income Statement Revenues Expenses Statement of Cash Flows Operating Activities Investing Activities Financing Activities Transactions and Events Continued

Interrelationship of Financial Statements Income Statement Revenues Expenses Ending Balance Sheet Assets Liabilities Stockholders’ Equity Statement of Cash Flows Operating Activities Investing Activities Financing Activities

Basic Accounting Equation + Stockholders’ Equity Assets = Liabilities Economic resources Economic obligations Net assets

Liquidity The term liquidity is used to describe how quickly an asset can be converted into cash or a liability paid.

Financial Flexibility Financial flexibility refers to the ability of a company to use its financial resources to adapt to change.

Operating Capability Operating capability refers to the ability of a company to maintain a given physical level of operations.

Three-Stage Process for Disclosing Information on the Balance Sheet 1. Identification of what items meet the definition of the elements. 2. Measurement (valuation) of the elements. 3. Reporting (classification) of the elements.

Elements of the Balance Sheet — Assets Assets are probable future economic benefits obtained or controlled by a company as a result of past transactions or events.

Elements of the Balance Sheet — Assets 1. The resource must be able to contribute directly or indirectly to the company’s future net cash inflows. 2. The company must be able to obtain the future benefit and control others’ access to it. 3. The transaction or event giving the company the right to or control over the benefit must have occurred.

Elements of the Balance Sheet — Assets Assets may be natural or man-made, tangible or intangible, and exchangeable or useful only in the company’s activities.

Elements of the Balance Sheet — Liabilities … of a company to transfer assets or provide services to other entities in the future as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations...L

Elements of the Balance Sheet — Stockholders’ Equity + Stockholders’ Equity Assets Liabilities = Equity is residual interest in the assets of a company that remain after deducting liabilities.

Measurement of the Elements of the Balance Sheet Present Value Net Realizable Value Current Market Value Current Cost Historical Cost

Measurement of the Elements of the Balance Sheet (Assets) The historical cost of an asset is the exchange price in the transaction in which the asset was acquired. The current cost of an asset is the amount of cash (or equivalent) that would be required on the date of the balance sheet to obtain the same asset. The present value of an asset is the net amount of future cash inflows into which the asset is expected to be converted less the present value of future cash outflows necessary to obtain those inflows. The net realizable value of an asset is the amount of cash (or equivalent) into which the asset is expected to be converted in the ordinary operations of the company, less any expected conversion costs. The current market value of an asset is the amount of cash (or equivalent) that could be obtained on the date of the balance sheet by selling the asset in an orderly liquidation.

Measurement of the Elements of the Balance Sheet (Liabilities) Initially, the amount of cash received when an obligation was incurred (historical proceeds); subsequent to incurrence, the historical amount may be adjusted for amortization. The current proceeds is the amount of cash that would be obtained if the same obligation were incurred. The net realizable value of a liability is the amount of cash expected to be paid to eliminate the liability in due course of business. The current market value of a liability is the amount of cash that would be required currently to eliminate the liability. The present value of future cash outflows to eliminate the liability in due course of business.

Limitations of the Balance Sheet Use of historical cost to value assets and liabilities does not help assess the likely amounts of future cash flows. “Human resources” or “intellectual capital,” such as high-quality management or highly creative employees are not included as assets. Many of the amounts that a company reports are based on estimates. In periods of inflation, the amounts listed do not show the “purchasing power” of its assets and liabilities.

Current Assets Current assets are cash and other assets that are expected to be converted into cash, sold, or consumed within one year or the normal operating cycle, whichever is longer.

Operating Cycle …process and sell the inventory, and collect the receivables, converting them back into cash. An operating cycle is the average time taken by a company to spend cash for inventory,...

Operating Cycle Flow Make Collections of Accounts Receivable 1. Collect cash 2. Incur bad debts Acquire Inventory 1. Pay cash 2. Incur accounts payable Make Sales )Revenues 1. Collect cash 2. Increase accounts receivable 3. Reduce deferred revenues Incur Cost of Goods Sold 1. Reduce inventory

Current Assets Cash equivalents are risk-free securities, such as money market funds and treasury bills that will mature in three months or less from the date acquired by the holder. Cash includes cash on hand and readily available in checking and savings accounts.

Current Assets Temporary investments in marketable securities include debt and equity securities that are classified as “trading securities” and “available-for-sale securities.”

Current Assets Receivables include accounts receivable and notes receivable with short-term maturity dates. They are listed at their estimated collectible amounts (net realizable values). Inventories include goods held for resale in the normal course of business plus, in the case of a manufacturing company, raw materials and goods in process inventories. Prepaid items include insurance, rent, office supplies and taxes that will not be converted into cash but will be consumed.

Current Liabilities Current liabilities are those obligations whose liquidation is expected to require the use of existing current assets, or the creation of other current liabilities.

Current Liabilities Obligations for items that have entered into the operating cycle (accounts payable and salaries payable). Advance collections for the future delivery of goods or performances of service (unearned rent and unearned ticket sales). 3. Other obligations that will be paid within one year or the operating cycle (estimated liabilities for short-term product warranties).

Working Capital Current Assets Current Liabilities = Working Capital

Long-Term Investments Investment items that management expects to hold for more than one year or the operating cycle, whichever is longer, are classified as long-term (noncurrent) investments.

Long-Term Investments A company makes investments for a variety of reasons. The company expects the market value of the investment to increase. The company wishes to receive income from interest or dividends. The company may desire to exercise control over another company or a supplier. The company may acquire property, plant, or equipment for future operations.

Property, Plant, and Equipment Also called fixed assets Property, plant, and equipment includes the tangible assets used in the firm’s operations.

Intangible Assets Intangible assets are those noncurrent economic resources that are used in the operations of the business but have no physical existence. Computer software costs Copyrights Goodwill Patents Franchises Trademarks ® a registered trademark

Intangible Assets A company may have three categories of intangible assets: 1. Intangible assets with finite useful lives. 2. Intangible assets with indefinite lives. 3. Goodwill.

Sometimes referred to as “deferred charges” Other Assets The Other Assets section occasionally is used to report miscellaneous assets that may not be readily classified within one of the previous sections. Sometimes referred to as “deferred charges”

Long-Term Liabilities Long-term liabilities are those obligations that are not expected to require the use of current assets or not expected to create current liabilities within one year or the normal operating cycle (whichever is longer).

Other Liabilities Deferred tax liabilities and obligations of a component of the company that is being discontinued are examples of items that might be included as other liabilities.

Conceptual Guidelines FASB suggested guidelines for developing homogeneous classes of assets and liabilities. Reporting assets according to their type or expected function in the central operations or other activities of the company. Reporting as separate items assets and liabilities that affect the financial flexibility of the company differently. Reporting assets and liabilities according to measurement method used to value the items.

A sole proprietorship is a single-owner company. Stockholders’ Equity A partnership involves two or more persons who have agreed to combine their capital and efforts in the operations of a company. The corporation is a complex business organization. Usually there is absentee ownership. A sole proprietorship is a single-owner company. Stockholders’ equity is the residual interest of the stockholders in the assets of the corporation.

Components of Stockholders’ Equity Contributed capital Retained earnings Accumulated other comprehensive income

Preferred stock receives preference in declared dividends. Stockholders’ Equity Contributed Capital Preferred stock receives preference in declared dividends. Legal capital is the minimum amount of stockholders’ equity that the corporation may not distribute as dividends. Common stock carries the right to vote at the annual stockholders’ meeting and to share in residual profits.

Stockholders’ Equity Contributed Capital A corporation sells 100 shares of its $5 par common stock for $30 per share. Cash 3,000 Common Stock, $5 par 500 Additional Paid-in Capital on Common Stock 2,500

Stockholders’ Equity Contributed Capital A corporation sells 20 shares of its $100 par preferred stock for $110 per share. Cash 2,200 Preferred Stock, $100 par 2,000 Additional Paid-in Capital on Preferred Stock 200

Stockholders’ Equity Contributed Capital A corporation sells 100 shares of its no-par common stock at $50 per share. Cash 5,000 Common Stock—No-Par Value 5,000

Stockholders’ Equity Retained earnings is the total amount of corporate net income that has not been distributed to stockholders as dividends. Uses of net income To use in daily operations To maintain its productive facilities For growth

Stockholders’ Equity 1. Unrealized increases (gains) or decreases (losses) in the market value of investments in available-for-sale securities. 2. Transaction adjustments from converting the financial statements of a company’s foreign operations into U. S. dollars. 3. Certain gains and losses on “derivative” financial instruments. 4. Certain pension liability adjustments. Comprehensive income includes both net income and other comprehensive income. Accumulated other comprehensive income might include four items:

Stockholders’ Equity If a corporation has more than one item of other comprehensive income, it may report the amount of each item in stockholders’ equity.

Stockholders’ Equity Or, it may report the total amount of accumulated other comprehensive income for all the items in stockholders’ equity. This approach requires a note to the statements.

Statement of Changes in Stockholders’ Equity This statement should show investments by and distributions to owners during the period, among other items. A corporation must disclose the changes in its stockholders’ equity account when issuing financial statements.

Statement of Changes in Stockholders’ Equity FASB Statement of Concepts No. 6 defined investments by owners and distributions to owners, as follows: Investments by owners are increases in the equity of a company resulting from transfers of something valuable to the company from other entities in order to obtain or increase ownership interests. Distributions to owners are decreases in the equity of a company caused by transferring assets, rendering services, or incurring liabilities to owners.

Statement of Changes in Stockholders’ Equity SCHEDULE A CARON MANUFACTURING COMPANY Exhibit 3-8 Statement of Changes in Stockholders’ Equity For Year Ended December 31, 2004 Accumulated Common Additional Other Stock Paid-in Retained Comprehensive $5 par Capital Earnings Income Total Balance, Jan. 1, 2004 $65,000 $143,400 $ 64,900 $10,000 $283,300 Unrealized increase in value of available- for-sale securities 2,000 2,000 Net income 62,500 62,500 Cash dividends paid (11,200 ) (11,200 ) Common stock issued 6,500 30,500 37,000 Balance, Dec. 31, 2004 $71,500 $173,900 $116,200 $12,000 $373,600

Summary of Accounting Policies APB Opinion No. 22 requires that a company include a description of all significant accounting policies as an integral part of its financial statements. In particular, when these principles and methods involve-- A selection from existing acceptable alternatives. Principles and methods peculiar to the industry in which the company operates. Unusual or innovative applications of GAAP.

Derivative Financial Instruments FASB Statement No. 107 requires a company to disclose the fair value of all its financial instruments, whether recognized or not on its balance sheet. The Statement also requires a company to disclose all significant concentrations of credit risk due to its financial instruments. A company typically makes these disclosures in the notes to its financial statements.

Derivative Financial Instruments Fair value is the amount at which the instrument could be purchased or sold in a current transaction between willing parties. FASB Statement No. 133 requires a company to recognize all derivative financial instruments as either assets or liabilities on the balance sheet. These instruments should be measured at fair value.

Derivative Financial Instruments FASB Statement No. 133 also requires the following information: The type of derivative instruments it holds. Its objectives in holding the instruments. Its strategies for achieving these objectives.

Contingent Liabilities and Assets Loss Disclosure No or Probable (?) Reasonably estimated (?) and Yes Report amount in financial statements Reasonably possible Disclose in notes to the financial statements

Subsequent Events A subsequent event is one that occurs between the balance sheet date and the date of issuance of the annual report. End of Accounting Period Annual Report Publication Date Subsequent Events

SEC Integrated Disclosures The Securities and Exchange Commission has the legal authority to prescribe accounting principles and reporting practices for all regulated companies. A regulated company must file a Form 10-K annual report with the SEC within 90 days of its fiscal year-end. This report must be filed electronically according to the EDGAR requirements.

SEC Integrated Disclosures The SEC requires comparative balance sheets for at least two years and comparative income statements and statements of cash flows for three years. The SEC requires specific disclosures of important accounting information for a five-year period. These include net sales or operating revenues, income (loss) from continuing operations, and related earnings per share, total assets, long-term obligations and redeemable stock, and cash dividends declared per share.

SEC Integrated Disclosures Management must include a discussion and analysis of the company’s financial condition, changes in financial condition, and results of operations.

SEC Integrated Disclosures Several disclosures must be made about the common stock’s market prices and dividends: The principal trading markets for the company’s common stock. The high and low market prices for each quarter in the last two years. The approximate number of shareholders. The dividends paid in the last two years. Any dividend transactions.

Balance Sheet Formats Most companies use the report form or the account form format in presenting their balance sheets.

Balance Sheet Formats Report Form Assets xxxx $xxx xxxx xxx Total assets $xxx Liabilities and Stockholders’ Equity Total liabilities and stockholders eq. $xxx

Balance Sheet Formats Account Form In the seldom-used financial position format, current assets and current liabilities are listed first to emphasize working capital. Liabilities and Stockholders’ Equity xxxx $xxx xxxx xxx Total liab. & stock. eq. $xxx Assets xxxx $xxx xxxx xxx Total assets $xxx

C 3 hapter The End