Chapter 2 The Balance Sheet Copyright © 2016 Pearson Education, Inc. 2-1

The Balance Sheet Also called the statement of condition or the statement of financial position Shows the financial condition of a company on a particular date Summarizes what the firm owns and what the firm owes to outsiders and to internal owners 2-2

Financial Condition Assets are what the firm owns. Liabilities are what the firm owes to outsiders. Stockholders’ equity is what the firm owes to internal owners. 2-3

Financial Condition 2-4

Financial Condition Consolidation Parent company owns more than 50% of voting stock. Financial statements are combined. 2-5

Financial Condition Balance Sheet Date The date the balance sheet is prepared Could be the end of the calendar year, fiscal year, quarter, etc. 2-6

Financial Condition Comparative Data SEC requires two-year audited balance sheets. Provides a reference point for determining changes in financial position 2-7

Financial Condition Balance Sheet Format Not prescribed by the FASB, SEC, or IASB Majority of firms prepare classified balance sheets. Differences in order of assets and liabilities 2-8

Financial Condition 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 Useful for evaluating trends within a firm Allows for making industry comparisons 2-9

Financial Condition 2-10

Assets Segregated according to how they are utilized Current Assets Property, Plant, and Equipment Other Assets 2-11

Assets Current Assets Continually used up and replenished Expected to be converted to cash within one year or one operating cycle 2-12

Assets Current Assets Operating cycle Working capital 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 2-13

Assets Current Assets Cash and cash equivalents Marketable securities Accounts receivable Inventories Prepaid expenses 2-14

Assets 2-15

Assets Current Assets – Cash and Cash Equivalents Cash awaiting deposit Cash in a bank account Short-term investments that can be converted to cash within three months 2-16

Assets Current Assets – Marketable Securities Short-term investments that can be converted to cash within a year Three categories Held to maturity Trading securities Securities available for sale 2-17

Assets Current Assets – Accounts Receivable Customer balances outstanding on credit sales Net realizable value – actual amount of account less an allowance for doubtful accounts 2-18

Assets Current Assets – Accounts Receivable Allowance for doubtful accounts Affects balance sheet valuation Important in assessing earnings quality Should reflect volume of credit sales, past experiences with customers, customer base, credit policies, collections practices, and economic conditions 2-19

Assets The allowance account for Sage Inc. represents approximately 5% of accounts receivable: 2-20

Assets Current Assets – Accounts Receivable There should be a consistent relationship between the rate of change in sales, accounts receivable, and the allowance for doubtful accounts. 2-21

Assets Sage Inc. 2-22

Assets To analyze the preceding information, consider the following: Are all three accounts changing in the same directions and at consistent rates of change? If the direction and rates of change are not consistent, what are possible explanations for these differences? If there is not a normal relationship between the growth rates, what are possible reasons for the abnormal pattern? 2-23

Assets For Sage Inc., Sales, accounts receivable, and the allowance for doubtful accounts have all increased. Allowance account has increased appropriately in relation to accounts receivable. Sales have grown at a much greater rate. More sales in cash have probably been collected. Sage will probably experience fewer defaults. 2-24

Assets Current Assets – Accounts Receivable Additional information helpful to the analysis of accounts receivable and the allowance account is provided in the schedule of “Valuation and Qualifying Accounts.” Additions Charged to Costs and Expenses Deductions 2-25

Assets Sage’s Inc. schedule from the Form 10-K 2-26

Assets “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 the firm has written off as accounts receivable they no longer expect to recover. Analyst should use this schedule to assess the probability that the firm is intentionally over- or underestimating the allowance account. Sage Inc. appears to estimate an expense fairly close to the actual amount written of each year. 2-27

Assets Current Assets – Inventories Items held for sale Items used in the manufacture of products that will be sold Major revenue producer for most companies 2-28

Assets Current Assets – Inventories Retail companies Finished goods Manufacturing companies Raw materials Work-in-process Service–oriented companies Little to no inventory 2-29

Assets 2-30

Assets Current Assets – Inventories Inventory Accounting Methods Method used has considerable impact on 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. Disclosure of inventory cost flow assumption is found in the notes. 2-31

Assets Current Assets – Inventories Inventory Accounting Methods First in, first out (FIFO) Last in, first out (LIFO) Average cost 2-32

Assets Example – 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 at the end of the year. Unit Cost Per Unit #1 $5 #2 $7 #3 $8 #4 $9 #5 $11 2-33

Assets Cost flow assumptions Resulting effect on the income statement and balance sheet 2-34

Assets Current Assets – Inventories Inventory Accounting Methods During a period of inflation, the LIFO method typically produces the highest cost of goods sold expense the lowest ending valuation of inventory undervalued inventories on the balance sheet cost of goods sold values at current cost of inventory items 2-35

Assets Current Assets – Inventories Inventory Accounting Methods During a period of inflation, the FIFO method typically produces the lowest cost of goods sold expense the highest ending valuation of inventory inventory values on the balance sheet that are at current cost cost of goods sold values below the current cost of inventory items 2-36

Assets 2-37

Assets Current Assets – 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 2-38

Assets Property, Plant, and Equipment (PP&E) Encompasses a company’s fixed assets Not used up during annual operations Produce economic benefits for more than one year Have physical substance Shown at book value on the balance sheet 2-39

Assets Property, Plant, and Equipment (PP&E) The relative proportion of fixed assets in a company’s asset structure will largely be determined by the nature of the business. Manufacturing firms typically have higher percentages of fixed assets than retailers or wholesalers. Firms with newly purchased assets will have higher percentages of fixed assets than firms with older fixed assets. 2-40

Assets PP&E – Depreciation Fixed assets (with the exception of land) are depreciated over the period of time they benefit the firm. Method of allocating the cost of long-lived assets Original cost less estimated residual value is spread over the asset’s expected life. 2-41

Assets PP&E – Depreciation Methods Straight-line method allocates an equal amount of expense to each year of the depreciation period. Accelerated methods apportion larger amounts of expense to earlier years of the asset’s depreciable life. Units-of-production method bases depreciation expense on actual use. 2-42

Assets Example – Assume that Sage Inc. purchases an artificial ski mountain for its Phoenix flagship store in order to demonstrate skis and allow prospective customers to test-run skis on a simulated course. The cost of the mountain is $50,000 and is expected to have a five-year useful life and $0 salvage value at the end of that period. 2-43

Assets 2-44

Assets 2-45

Assets Property, Plant, and Equipment (PP&E) Land Buildings Leasehold improvements Construction in progress Equipment 2-46

Assets PP&E – Land Property used in business Not investment property 2-47

Assets PP&E – Buildings Buildings owned by the company Stores Corporate offices 2-48

Assets PP&E – Leasehold Investments Additions made to leased structures Improvements made to leased structures Revert to the property owner when the lease expires Amortized by the lessee over the economic life of the improvement (or the life of the lease) 2-49

Assets PP&E – Construction in Progress Costs of constructing new buildings that are not yet complete 2-50

Assets PP&E – Equipment Original cost of machinery and equipment used in business operations 2-51

Assets 2-52

Assets Goodwill 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 If no loss of value has occurred, goodwill remains on the balance sheet. If the book value exceeds the fair value, the excess must be written off as an impairment expense. 2-53

Assets Other Assets Property held for sale Start-up costs associated with a new business Cash surrender value of life insurance policies Long-term advance payments Intangible assets (other than goodwill) 2-54

Liabilities Represent claims against assets Current liabilities Must be satisfied in one year or one operating cycle Noncurrent liabilities Obligations with maturities beyond one year 2-55

Liabilities Current Liabilities Accounts payable Notes payable Current portion of long-term debt Accrued liabilities Unearned revenue 2-56

Liabilities Accounts Payable Short-term obligations that arise from credit extended by suppliers for the purchase of goods and services Eliminated when the bill is satisfied Increase and decrease depending on credit policies, economic conditions, and cyclical nature of operations 2-57

Liabilities 2-58

Liabilities Short-Term Debt Also referred to as notes payable Short-term obligations in the form of promissory notes Lines of credit to suppliers or financial institutions 2-59

Liabilities Current Maturities of Long-term Debt Portion of the principal of long-term debt that will be repaid during the upcoming year 2-60

Liabilities Accrued Liabilities Result from recognition of an expense prior to actual payment of cash Reserve accounts Set up for the purpose of estimating obligations for items such as warranty costs, sales returns, or restructuring charges Identified in the notes to the financial statements 2-61

Liabilities Example – Assume that a company has a $100,000 note outstanding with 12% interest due in semiannual installments on March 31 and September 30. For a balance sheet prepared on December 31, interest will be accrued for three months (October, November, and December). The December 31 balance sheet would include an accrued liability of $3,000: $10,000 x 0.12 = $12,000 annual interest $12,000/12 = $1,000 monthly interest $1,000 x 3 = $3,000 accrued interest for three months 2-62

Liabilities Unearned Revenue or Deferred Credits Result from payments received in advance for services and products Transferred to a revenue account when the service is performed or the product is delivered 2-63

Liabilities Deferred Federal Income Taxes Result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income Depreciation methods are the most common source for temporary differences. 2-64

Liabilities Deferred Federal Income Taxes Other sources of temporary differences Installment sales Long-term contracts and leases Warranties and service contracts Pensions and other employee benefits Subsidiary investment earnings 2-65

Liabilities Deferred Federal Income Taxes Permanent differences in income tax accounting do not affect deferred taxes. Municipal bond revenue Life insurance premiums 2-66

Liabilities Deferred Federal Income Taxes Valuation allowance Used to reduce deferred tax assets to expected realizable amounts Used when it is more likely than not that some of the deferred tax assets will not be realized 2-67

Liabilities Example – Assume that a company has a total annual revenue of $500,000, expenses other than depreciation of $250,000, and a depreciation expense of $100,000 for tax accounting and $50,000 for financial reporting. The income for tax reporting purposes would be computed two ways, assuming a 34% tax rate: 2-68

Liabilities Taxes actually paid ($51,000) are less than the tax expense ($68,000) reported in the financial statements. To reconcile the $17,000 difference between the expense recorded and the cash outflow, there is a deferred tax liability of $17,000: 2-69

Liabilities 2-70

Liabilities Deferred Federal Income Taxes Deferred taxes are not always classified as current liabilities. They may also appear on the balance sheet as a current asset, a noncurrent asset, or a noncurrent liability. 2-71

Liabilities Long-term Debt Long-term notes payable Mortgage Debentures Bonds payable Convertible debt Long-term warranties 2-72

Liabilities Capital Lease Obligations A “purchase” rather than a “lease” Affect both balance sheet and income statement Disclosures found in the notes, often under both the PP&E note and the commitments and contingencies note 2-73

Liabilities Pensions and Postretirement Benefits Pensions are cash compensation paid to retired employees. Postretirement benefits are benefits other than pensions that employers promise to pay for retired employees. Can appear under the liability section of the balance sheet 2-74

Liabilities Commitments and Contingencies Commitments refer to contractual agreements that will have a significant financial impact in the future. Contingencies refer to potential liabilities (such as possible damage awards assessed in lawsuits). 2-75

Stockholders’ Equity Also called shareholders’ equity Residual interest in assets that remains after deducting liabilities Owners bear greatest risk and benefit from greatest rewards. 2-76

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 2-77

Stockholders’ Equity Common Stock Dividends are declared at the discretion of a company’s board of directors Amount listed on the balance sheet is based on the par or stated value of the shares issued (which bears no relationship to actual market price). 2-78

Stockholders’ Equity Additional Paid-In Capital Reflects the amount by which the original sales price of the stock shares exceeded par value 2-79

Stockholders’ Equity Retained Earnings Sum of every dollar a company has earned since 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 dividends Measurement of all undistributed earnings 2-80

Stockholders’ Equity Retained Earnings Key link between the income statement and the balance sheet Unless there are unusual transactions affecting the retained earnings account, Beginning retained earnings Net income (loss) Ending retained earnings – Dividends = ± 2-81

Stockholders’ Equity Other Equity Accounts Preferred stock Accumulated other comprehensive income (expense) Treasury stock Equity attributable to noncontrolling interests 2-82

Stockholders’ Equity 2-83

Stockholders’ Equity Other Equity Accounts – Preferred Stock Carries a fixed annual dividend payment Carries no voting rights 2-84

Stockholders’ Equity Other Equity Accounts – Accumulated Other Comprehensive Income (Expense) 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 2-85

Stockholders’ Equity Other Equity Accounts – Treasury Stock Repurchased shares of stock that are not retired Shown as an offsetting account 2-86

Stockholders’ Equity Other Equity Accounts – Equity Attributable to Noncontrolling Interests Represents the equity interest a firm has in companies whose financial statement have been consolidated with the firm’s statements but that are not 100% owned by the firm 2-87

Quality of Financial Reporting Economic recession of 2008 and many market gyrations since can be traced directly to overvaluation of balance sheet assets. When financial reporting does not reflect economic reality, quality and usefulness of information are significantly impaired. Type of debt used to finance assets, commitments and contingencies, and the classification of leases relate directly to quality of financial reporting. 2-88

Quality of Financial Reporting “Commitments and Contingencies” disclosure in the notes to financial statements provide important information about off-balance sheet financing and other complex financing arrangements. Enron is a prime example of a company with enormous activity reported in the “Commitments and Contingencies” disclosure. 2-89

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 find many of the same accounts listed under different titles. 2-90

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