Chapter 5: The Balance Sheet and The Statement of Cash Flows Intermediate Accounting, 10th Edition Kieso, Weygandt, and Warfield Chapter 5: The Balance Sheet and The Statement of Cash Flows Prepared by Krishnan Ranganathan, Angelo State University, San Angelo, Texas 2

Part 1: The Balance Sheet 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Balance Sheet: Usefulness The balance sheet provides information for evaluating the capital structure and for computing rates of return. It is also useful for analyzing an enterprise’s liquidity (to pay current & maturing debt) solvency (to pay debt as it matures) financial flexibility (responding to unexpected needs and opportunities) 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Balance Sheet: Limitations Most assets and liabilities are stated at historical cost. Judgments and estimates are used in determining many of the items. The balance sheet does not report items that can not be objectively determined. It does not report information regarding off- balance sheet financing. 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Balance Sheet: Classification Guidelines for reporting items separately: Assets and liabilities that differ in their type or expected function in the central operations Assets and liabilities that have different implications for the enterprise’s financial flexibility Assets and liabilities with different general liquidity characteristics 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Balance Sheet: Classification Assets Liabilities and Equity Current Assets Long-term investments Property, plant, and equipment Intangible assets Other assets Current liabilities Long-term debt Owners’ equity Capital stock Additional paid-in capital Retained earnings 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) Current Assets Current assets are expected to be consumed, sold, or converted into cash: either in one year or in the operating cycle, whichever is longer. Current assets are presented in order of liquidity. The following valuation principles are used: short term investments at fair value accounts receivable at net realizable value 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Long-Term Investments Long term investments may be: investments in securities (bonds, stock) investments in fixed assets (land not used in operations) investments set aside in special funds (sinking fund) investments in nonconsolidated subsidiaries or affiliated companies 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) Current Liabilities Current liabilities are liquidated either through the use of current assets, or by creation of other current liabilities Examples of current liabilities include: payables resulting from acquisitions of goods and services collections received in advance of services other liabilities which will be paid in the short term 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) Long Term Liabilities Long-term obligations are those not expected to be paid within the operating cycle. Examples are: obligations arising from specific financing situations (issuance of bonds) obligations arising from ordinary business operations (pension obligations) obligations that are contingent (product warranties) 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Balance Sheet: Additional Information Reported Additional information may be: information not presented elsewhere, or information that qualifies items in the balance sheet Supplemental information includes: material events having an uncertain outcome explanations regarding accounting policies covenant restrictions 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Balance Sheet: Techniques of Disclosure Parenthetical explanations (following the items in the balance sheet) Notes (to the balance sheet) Cross references and contra items (where assets and liabilities may be cross referenced) Supporting schedules (as for fixed assets depreciation) 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) Statement of Cash Flows 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

The Cash Flow Statement The cash flow statement provides information about: the cash receipts (cash inflows) and uses of cash (cash outflows) during the year Inflows and outflows are reported for: operating, investing and financing activities during the year. 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Statement of Cash Flows Operating activities Investing Financing inflows Cash Pool Operating activities Investing Financing outflows 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Preparing a Statement of Cash Flows There are TWO methods of preparing the statement of cash flows: the indirect method and the direct method The indirect method (discussed in Chapter 5) derives cash flows from accrual basis statements. The direct method determines cash flows directly for each source or use of cash 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

The Statement of Cash Flows: Indirect method Accrual Basis Statements Cash Flow Statement Income Statement items & Changes in Current Assets and Current Liabilities Operating activities: Adjust net income for accruals and non cash charges to get cash flows Balance Sheet: Changes in Non-Current Assets Investing activities: Inflows from sale of assets and Outflows from purchases of assets Balance Sheet: Changes in Non-Current Liabilities and Equity Financing activities: Inflows and outflows from loan and equity transactions 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Indirect Method: Example Intelmarkets begins operations on 1.1.2000. The income statement and balance sheet for year 2000 are as follows: Income Statement Revenues: $ 200,000 Less: Expenses ($150,000) Net Income before Tax: $ 50,000 less: Income Tax ($ 15,000) Net Income after Tax $ 35,000 Balance Sheet (see next slide) 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Indirect Method: Example Balance Sheet Dec 31, 2000 Jan 1, 2000 Assets: Cash $ 25,000 $ -0- Accounts Receivable $ 32,000 $ -0- Inventory $ 29,000 $ -0- Land $110,000 $ -0- Total $196,000 $ -0- Liabilities and Equity: Accounts Payable $ 24,000 $ -0- Common Stock $147,000 $ -0- Retained Earnings $ 25,000 $ -0- Total $196,000 $ -0- 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Operations: Net Outflow 2,000 Operating Activities Net Income after Tax $35,000 Accounts Receivable +$ 32,000 Inventory +$ 29,000 Accounts Payable +$ 24,000 Accrual Basis Net Income after Tax $35,000 Less: Increase in A/Rec ($ 32,000) Less: Increase in Inventory($ 29,000) Add: Increase in Accounts Payable $ 24,000 Cash Flow Changes between beginning and ending balances Operations: Net Outflow 2,000 See explanations next slide 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) Operating Activities A/Rec increased by $32,000 Cash collections are less than revenue recognized Reduce net income by $32,000 to derive cash flows from operations 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) Operating Activities Inventory increased by $29,000 Cost of goods sold for the year decreases by $29,000. Reduce net income by $29,000 to derive cash flows from operations Net income for the year increases by $29,000 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Investing and Financing Activities Land + $110,000 Accrual Basis Investing Activities: Purchase of Land: ($110,000) Outflow ($110,000) Cash Flow Financing Activities: Issue of Common Stock: $147,000 Dividends paid: ($10,000) Inflow $137,000 Common Stock +$147,000 Retained Earnings +$ 25,000 Beg Bal: $0 Net Income: $35,000 less: Dividends ($10,000) End Balance: $25,000 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) Cash Flows: Summary Cash used by operating activities:($ 2,000) Cash used by investing activities:($110,000) Cash from financing activities: $137,000 Net inflow for the year $ 25,000 Beginning cash balance: $ -0- Ending cash balance $ 25,000 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) Ratio Analysis 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) Ratios Ratio analysis expresses the relationship between selected financial data. These relationships can be expressed as: percentages rates, or proportions 1 2 3 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) Types of Ratios What is measured Examples Type Liquidity ratios Short-term ability to pay maturing obligations Current ratio Quick assets ratio Activity ratios Effectiveness in using assets employed Receivables turnover Inventory turnover Profitability ratios Degree of success or failure for a given period Rate of return on assets Earnings per share Coverage ratios Degree of protection for long-term creditors and investors Debt to Total assets Times interest earned 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.) COPYRIGHT Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. 11/6/2018 Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)