Understanding Financial Statements NINTH EDITION Lyn M. Fraser Aileen Ormiston Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

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Chapter 2: The Balance Sheet “Old accountants never die; they just lose their balance” --Anonymous Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

The Balance Sheet Also called the statement of condition or the statement of financial position Shows the financial condition or financial position of a company on a particular date Summarizes what the firm owns and what the firm owes to outsiders and to internal owners Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Financial Condition Assets = Liabilities + Stockholders’ equity Assets are what the firm owns. Liabilities are what the firm owes to outsiders. Stockholders’ equity is what the firm owes to internal owners. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Consolidation When a parent owns more than 50% of the voting stock of a subsidiary, the financial statements are combined even though they are separate legal entities. The statements are consolidated, because the companies are in substance one company, given the proportion of control by the parent. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Balance Sheet Date Prepared on a particular date at the end of an accounting period End of accounting period can be the end of a calendar year, fiscal year, or interim period such as a year, a quarter, etc. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Comparative Data SEC requires that the annual report includes two-year audited balance sheets and three-year audited statements of income and cash flow. Comparative data provides a reference point for determining changes in financial position over time. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Common-Size Balance Sheet Expresses each item on the balance sheet as a percentage of total assets Reveals the composition of assets Form of vertical ratio analysis that allows comparison of firms Useful for evaluating trends within a firm and to make industry comparisons Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

R.E.C. Inc. Common-Size Balance Sheet (Percent) 2010 2009 Cash 4.3 3.1 Marketable Securities 5.5 10.6 Accounts receivable, less doubtful accounts 9.4 11.0 Inventories 49.4 48.4 Prepaid expenses 0.5 1.0 Total Current Assets 69.1 74.1 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Assets Segregated according to how they are utilized Current Assets Property, Plant, and Equipment Accumulated depreciation and amortization Other Assets Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

R.E.C. Inc. Consolidated Balance Sheets as December 31, 2010 and 2009 (in Thousands) 2010 2009 Cash $ 4,061 $ 2,382 Marketable securities 5,272 8,004 Accounts receivable, less doubtful accounts 8,960 8,350 Inventories 47,041 36,769 Prepaid expenses 512 759 Total current assets 65,846 56,264 Property, Plant, and Equipment Land 811 811 Buildings and leasehold improvements 18,273 11,928 Equipment 21,523 13,768 40,607 26,507 Less accumulated depreciation and amortization 11,528 7,530 Net property, plant, and equipment 29,079 18,977 Other Assets 373 668 Total Assets $95,298 $75,909 _________ _________ Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Assets Include cash and assets expected to be converted to cash within one year or one operating cycle Refer to assets that are continually used up and replenished Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

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 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Assets Cash Marketable Securities Accounts Receivable Inventories Prepaid Expenses Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Cash and Marketable Securities Cash awaiting deposit Cash in a bank account Marketable Securities Short-term investments of cash that is not needed U.S. Treasury bills, certificates, notes, bonds, commercial paper Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Cash and Marketable Securities Valuation of marketable securities requires the separation of investment securities into three categories. 1. Held to maturity 2. Trading securities 3. Securities available for sale Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Cash and Marketable Securities Held to maturity Positive intent and ability to hold to maturity Reported at amortized cost Trading securities Held for resale in the short term Reported at fair value with unrealized gains and losses included in earnings Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Cash and Marketable Securities Securities available for sale Debt and equity securities that are not classified as one of the other two categories Reported at fair value with unrealized gains or losses included in comprehensive income Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Statement of Financial Accounting Standards No. 159 Permits entities to measure many financial instruments at fair value Does not apply to investments in consolidated subsidiaries nor equity securities accounted for under the equity method Most significantly affects financial institutions and insurance companies Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Accounts Receivable Customer balances outstanding on credit sales Reported on the balance sheet at net realizable value (actual amount less an allowance for doubtful accounts) Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Accounts Receivable Allowance for doubtful accounts Affect balance sheet valuation and bad debt expense on income statement Can be important in assessing earnings quality Should reflect volume of credit sales, past experience with customers, customer base, credit policies, collections practices, and economic conditions Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Information from R.E.C. Inc. Balance Sheet and Income Statement Growth Rate (In Thousands) 2010 2009 (% Change) Net Sales $215,600 $2,382 40.9 Accounts receivable (total) 9,408 8,767 7.3 Allowance for doubtful accounts 448 417 7.4 To analyze the above information consider the following: Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Information from R.E.C. Inc. Balance Sheet and Income Statement Are all three accounts changing in the same direction and at consistent rates of change? If the direction and rates are not consistent, what are possible explanations for these differences? If there is not a normal relationship between growth rates, what are possible reasons for the abnormal pattern? Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Information from R.E.C. Inc. Balance Sheet and Income Statement All three accounts increased, but sales have grown at a much greater rate. R.E.C. Inc. has collected more sales in cash, and thus will have potentially fewer defaults. Allowance account has increased appropriately in relation to accounts receivable. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

R.E.C. Inc. Valuation and Qualifying Accounts December 31, 2010, 2009, and 2008 Balance at Beginning of Year Additions Charged to Costs and Expenses Deductions Balance at End of Year Allowance for doubtful accounts 2010 $417 $271 $240 $448 2009 $400 $217 $200 2008 $391 $259 $250 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

R.E.C. Inc. Valuation and Qualifying Accounts “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 that the firm has written off as accounts receivable they no longer expect to recover from customers. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

R.E.C. Inc. Valuation and Qualifying Accounts Analyst should use this schedule to assess the probability that the firm is intentionally over- or under-estimating the allowance account. R.E.C. Inc. appears to estimate an expense fairly close to the actual expense that has been incurred. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventories Items held for sale or used in the manufacture of products that will be sold Retail Company (one type of inventory) Finished goods Manufacturing Company (three types of inventory) Raw materials Work-in-process Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventories Proportion of inventories at the manufacturing level Inventories as a Percentage of Total Assets % Manufacturing Pharmaceutical preparations 20.4 Household Furniture 33.3 Sporting and athletic goods 39.6 Source: Data from The Risk Management Association, Annual Statement Studies, Philadelphia, PA, 2007. © “2008” by RMA-The Risk Management Association. All Rights Reserved. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventories Proportion of inventories at the wholesale level Inventories as a Percentage of Total Assets % Wholesale Drugs 30.4 Furniture 30.1 Sporting and recreational goods 44.8 Source: Data from The Risk Management Association, Annual Statement Studies, Philadelphia, PA, 2007. © “2008” by RMA-The Risk Management Association. All Rights Reserved. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventories Proportion of inventories at the retail level Inventories as a Percentage of Total Assets % Retail Pharmacies and drug stores 34.6 Furniture stores 48.9 Sporting goods stores 57.8 Source: Data from The Risk Management Association, Annual Statement Studies, Philadelphia, PA, 2007. © “2008” by RMA-The Risk Management Association. All Rights Reserved. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventory Accounting Methods Method used has a considerable impact on a company’s 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. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventory Accounting Methods Three cost flow assumptions most frequently used by U.S. companies FIFO (First In, First Out) LIFO (Last In, First Out) Average cost Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventory Accounting Methods FIFO LIFO Average Cost Cost of Goods Sold (Income Statement) first purchases last purchases (close to current cost) average of all purchases Inventory Valuation (Balance Sheet) last purchases (close to current cost) first purchases average of all purchases Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventory Accounting Methods 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. Item Purchase Price #1 $5 #2 $7 #3 $8 #4 $9 #5 $11 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventory Accounting Methods The cost flow assumptions for each method are shown below: Accounting Method Goods Sold Goods Remaining in Inventory FIFO #1, #2, #3 #4, #5 LIFO #5, #4, #3 #2, #1 Average Cost [Total cost/5] x 3 [Total cost/5] x 2 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventory Accounting Methods The resulting effect on the income statement and balance sheet are shown: Accounting Method Cost of Goods Sold (Income Statement) Inventory Valuation (Balance Sheet) FIFO $20 LIFO $28 $12 Average Cost $24 $16 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventory Accounting Methods LIFO during inflation Produces the highest cost of goods sold expense and the lowest ending inventory valuation Reduces taxes and reported earnings Cost of goods sold valued at current cost of inventory items Undervalued inventories on balance sheet Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventory Accounting Methods FIFO during inflation Produces the lowest cost of goods sold expense and the highest ending inventory valuation Increases taxes and reported earnings Balance sheet inventory valued at current cost Undervalued inventories on income statement Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Inventory Accounting Methods Disclosure of inventory cost flow assumption is found in the notes. Inventory reported on balance sheet is at the lower of cost or market. Companies may use more than one method for inventories in the U.S. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

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 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Property, Plant, and Equipment (PP&E) Encompasses a company’s fixed assets Also called tangible, long-lived, and capital assets Not used up during annual operations Produce economic benefits for more than one year Have physical substance Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Property, Plant, and Equipment (PP&E) Fixed assets other than land are “depreciated” over the period of time they benefit the firm. The process of depreciation is a method of allocating the cost of long-lived assets. Original cost less estimate residual value is spread over the asset’s expected life. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Property, Plant, and Equipment (PP&E) On any balance sheet date, PP&E is shown at book value (the difference between original cost and accumulated depreciation to date). Several choices and estimates must be made to determine the annual depreciation expense of an asset. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Property, Plant, and Equipment Depreciation Methods Straight-line method allocates an equal amount of expense to each year of the depreciation period. Accelerated method apportions larger amounts of expense to earlier years of the asset’s depreciable life. Units-of-production method bases depreciation expense on actual use. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Property, Plant, and Equipment (PP&E) Land refers to property used in business, not investment property. Leasehold investments are additions or improvements made to leased structures. Construction in progress are the costs of constructing new buildings that are not yet complete. Equipment represents the original cost of the machinery and equipment used in business operations. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Property, Plant, and Equipment (PP&E) Proportion of fixed assets in a company’s asset structure is determined by nature of the business. Fixed assets are most prominent at the manufacturing level. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Property, Plant, and Equipment Proportion of fixed assets at the manufacturing level Net Fixed Assets as a Percentage of Total Assets % Manufacturing Pharmaceutical preparations 24.0 Household Furniture 23.6 Sporting and athletic goods 14.9 Source: Data from The Risk Management Association, Annual Statement Studies, Philadelphia, PA, 2007. © “2008” by RMA-The Risk Management Association. All Rights Reserved. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Property, Plant, and Equipment Proportion of fixed assets at the wholesale level Net Fixed Assets as a Percentage of Total Assets % Wholesale Drugs 9.7 Furniture 11.9 Sporting and recreational goods 9.5 Source: Data from The Risk Management Association, Annual Statement Studies, Philadelphia, PA, 2007. © “2008” by RMA-The Risk Management Association. All Rights Reserved. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Property, Plant, and Equipment Proportion of fixed assets at the wholesale level Net Fixed Assets as a Percentage of Total Assets % Retail Pharmacies and drug stores 12.8 Furniture stores 19.5 Sporting good stores 15.9 Source: Data from The Risk Management Association, Annual Statement Studies, Philadelphia, PA, 2007. © “2008” by RMA-The Risk Management Association. All Rights Reserved. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Other Assets Can include many other noncurrent items: Property held for sale Start-up costs in connection with a new business Cash surrender value of life insurance policies Long-term advance payments Long-term investments Intangible assets Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Other Assets Intangible Assets Goodwill recognized in business combinations Patents Trademarks Copyrights Brand Names Franchises Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Other Assets Goodwill Most important intangible asset for analytical purposes because of potential materiality 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 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Liabilities Represent claims against assets and include Current Liabilities (accounts payable, notes payable, current maturities of long-term debt, accrued liabilities, unearned revenue or deferred credits, deferred federal income taxes) Noncurrent liabilities (long-term debt, capital lease obligations, postretirement benefits other than pensions, commitments and contingencies, hybrid securities) Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Liabilities Current liabilities Current liabilities must be satisfied in one year or one operating cycle and include Accounts payable Notes payable Current portion of long-term debt Accrued liabilities Unearned revenue Deferred taxes Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Accounts Payable Short-term obligations that arise from credit extended by suppliers for the purchase of goods and services Account is eliminated when bill is satisfied Increase and decrease depending on credit policies, economic conditions, and cyclical nature of operations Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Accounts Payable R. E. C. Inc Accounts Payable R.E.C. Inc. Consolidated Balance Sheets (in Thousands) 2010 2009 Current Liabilities Accounts payable $14,294 $7,591 Notes Payable 5,614 6,012 Current maturities of long-term debt 1,884 1,516 Accrued liabilities 5,669 5,313 Total current liabilities 27,461 20,432 Accounts payable almost doubled between 2009 and 2010. Analysis should include exploration of this increase. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Notes Payable Short-term obligations in the form of promissory notes Lines of credit to suppliers or financial institutions Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Current maturities of long-term debt Portion of the principal of long-term debt that will be repaid during the upcoming year Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Accrued Liabilities Result from recognition of an expense prior to actual payment of cash Recorded as reserve accounts Reserve accounts are set up to estimate obligations for certain items identified in the notes Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Accrued Liabilities Statement of Financial Accounting Standard No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” Prohibits recognition of a liability for a cost associated with an exit or disposal activity unless and until a liability has actually been incurred Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Unearned Revenue or Deferred Credits Result from payments received in advance for services or products Transferred to a revenue account when service is performed or product is delivered Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Deferred Federal Income Taxes Result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income Intended to take advantage of all available tax deferrals to reduce actual tax payments, while showing the highest possible amount of reported net income Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Deferred Federal Income Taxes Classified as current or noncurrent on the balance sheet Can appear on the balance sheet as a current asset, current liability, noncurrent asset, or noncurrent liability Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Deferred Federal Income Taxes Temporary differences can be caused by choice of accounting method for Depreciation Installment sales Long-term contracts and leases Warranties and service contracts Pensions and other employee benefits Subsidiary investment earnings Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Deferred Federal Income Taxes Permanent differences in income tax accounting do not affect deferred taxes and include Municipal bond revenue Life insurance premiums Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Deferred Federal Income Taxes A valuation allowance is used to reduce deferred tax assets to expected realizable amounts when it is determined that it is more likely than not that some of the deferred tax assets will not be realized. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Noncurrent Liabilities Obligations with maturities beyond one year Long-term debt Capital lease obligations Postretirement benefits other than pensions Commitments and contingencies Hybrid securities Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Noncurrent Liabilities Long-term debt Bonds Long-Term Notes Payable Mortgages Obligations under leases Pension Liabilities Long-Term Warranties Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Noncurrent Liabilities Capital lease obligations Are, in substance, a “purchase” rather than a “lease” Affect both balance sheet and income statement Disclosures found in the notes, often under both the property, plant, and equipment note and the commitments and contingencies note Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Noncurrent Liabilities Postretirement benefits other than pensions Can appear under the liability section of the balance sheet Can have a significant impact on corporate balance sheets Can also impact profitability by substantially increasing the recognition of annual postretirement benefit expense Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Noncurrent Liabilities Commitments and contingencies Intended to draw attention to the fact that required disclosures can be found in the notes to the financial statements Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Noncurrent Liabilities Commitments and contingencies Commitments refer to contractual agreements that will have a significant financial impact on the company in the future. Contingencies refer to potential liabilities of the firm such as possible damage awards assessed in lawsuits. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Noncurrent Liabilities Hybrid Securities Have the characteristics of both debt and equity Also called mandatorily redeemable preferred stock Financial instrument is preferred stock, but the issuing company must retire the shares at a future date. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stockholders’ Equity Final section of balance sheet Also called shareholders’ equity Residual interest in assets that remains after deducting liabilities Owners bear greatest risk and benefit from greatest rewards. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stockholders’ Equity 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 Dividends are declared at the discretion of a company’s board of directors. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stockholders’ Equity Additional paid-in capital Reflects the amount by which the original sales price of the stock shares exceeded par value Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stockholders’ Equity Retained Earnings Sum of every dollar a company has earned since its 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 stock Measurement of all undistributed earnings Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stockholders’ Equity Retained Earnings Key link between income statement and balance sheet Beginning Net Ending retained ± income – Dividends = retained earnings (loss) earnings Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stockholders’ Equity Other equity accounts Preferred stock Accumulated other comprehensive income Treasury stock Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Other Equity Accounts Preferred stock Carries a fixed annual dividend payments Carries no voting rights Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Other Equity Accounts Other comprehensive income 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 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

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 also find many of the same accounts listed under a variety of different titles. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall