Chapter 4 The Balance Sheet

Individual Balance Sheet Accounts

Current Assets Current assets include assets that are expected to be used within one year or the operating cycle, if longer The operating cycle involves the use of cash to buy inventories, selling the inventory to create accounts receivable, and the collection of those receivables In practice, one year is the common definition Financial Accounting, 7e Stice/Stice, 2006 © Thomson

The Operating Cycle Cash Collections Purchases Receivables Inventories Sales Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Current Assets Cash includes coins and currency on hand; bank accounts; and short-term securities Accounts receivable are amounts owed by customers An estimate of uncollectible accounts is deducted Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Current Assets Inventory represents goods held for sale in the normal course of business Prepaid expenses are payments in advance for operating expenses, e.g., insurance and rent Investment securities are publicly-traded stocks and bonds held with the intent to sell within a year Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Current Assets Current assets are listed on the balance sheet in the order of their liquidity, with the most liquid assets listed first Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Long-Term Assets Expected to last longer than one year Common categories include Investments Property, plant, and equipment Intangible assets Other assets Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Long-Term Assets Long-term investments include ownership of stocks and bonds to Exercise influence over other companies (stocks) Earn income from Interest (bonds) Dividends (stocks) Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Long-Term Assets Property, plant, and equipment (PP&E) are fixed assets that benefit more than one accounting period They include land, buildings, machinery, tools, furniture, and vehicles Accumulated depreciation reflects the wear and tear since the original purchase and decreases PP&E Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Long-Term Assets Intangible assets have no physical existence, but have some intrinsic value, generally from contract rights Patents Trademarks Copyrights Franchises Goodwill only recorded when one company buys another and pays more than the fair value of the identifiable assets Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Long-Term Assets The other assets category contains long-term assets not reportable under the previous categories e.g., a deferred tax asset occurs when a loss or expense is recognized for financial reporting purposes, but will be deducted on the tax return in a later year Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Current Liabilities Obligations expected to be paid out of current assets within one year Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Current Liabilities Accounts payable are created when a company buys merchandise or supplies on credit Accrued liabilities represent expenses incurred (e.g., salaries, interest, taxes), but not yet paid Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Current Liabilities Short-term loans payable are formal, interest-bearing loans expected to be paid within one year The current portion of long-term debt is the portion of these liabilities expected to be paid within one year from the balance sheet date Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Current Liabilities Unearned revenue is the obligation to provide services to customers who have paid in advance Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Long-Term Liabilities Long-term liabilities are obligations not expected to be paid or otherwise satisfied within one year Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Long-Term Liabilities Long-term debt includes long-term notes, bonds, and mortgages Capital lease obligations represent leases of plant assets which are equivalent to debt-financed purchases Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Long-Term Liabilities Deferred tax liability: income tax expected to be paid in future years on income already reported on the income statement Pension obligations and other post-retirement obligations relate to a company’s promise to pay benefits after the employees’ retirement Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Stockholders’ Equity The residual interest in a corporation The owners’ paid-in capital can take the form of common stock or preferred stock Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Stockholders’ Equity Common stockholders Have the most risk Have the potential to reap the greatest return Common stock amounts are reported at Par value (the amount printed on the certificates) Additional paid-in capital (the amount paid above par) Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Stockholders’ Equity Preferred stockholders Usually have a fixed return on their investment Have fewer ownership rights than common stockholders Typically do not have voting rights Have lower risk than common stockholders Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Stockholders’ Equity Retained earnings is the cumulative amount of profit that has not been distributed to stockholders as dividends Increased by net income Decreased by net losses dividends Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Stockholders’ Equity Treasury stock: the company’s own shares that have been repurchased The amount of treasury stock is subtracted from stockholders’ equity A company purchases treasury stock to Show confidence in the value of the shares Distribute cash to stockholders Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Stockholders’ Equity Accumulated other comprehensive income Reports the movement of market prices from certain investments and certain exchange rates May arise from Foreign currency translation adjustments Unrealized gains and losses on available-for-sale-securities Unrealized gains and losses on derivatives Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Accumulated Other Comprehensive Income Foreign currency translation adjustments Arise from the change in equity of foreign subsidiaries as a result of changes in foreign currency exchange rates Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Accumulated Other Comprehensive Income Unrealized gains and losses on available-for-sale-securities Unrealized gains and losses are fluctuations in the market prices of securities before they are sold Available-for-sale-securities are those a company does not intend to sell in the short-run Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Accumulated Other Comprehensive Income Unrealized gains and losses on derivatives Derivatives are financial instruments that derive their value from the movement of a price, an exchange rate, an interest rate, or an interest rate associated with another item Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Form of the Balance Sheet

Form of the Balance Sheet Side-by-side form Assets on the left-hand side Liabilities and owners’ equity on the right-hand side Columnar form Assets, liabilities, and owners’ equity presented vertically Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Form of the Balance Sheet Current assets and current liabilities are listed by their liquidity Current assets and current liabilities are normally listed before long-term assets and liabilities Balance sheets are generally presented in a comparative format Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Foreign Balance Sheets PP&E is frequently listed first Current assets and current liabilities are frequently netted together as working capital Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Recognition and Valuation

Recognition Recognition: an amount is recorded and reported in the financial statements As an alternative, disclosure conveys financial information in the form of narrative notes Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Recognition Recognition is the preferred method of financial reporting when it is appropriate An asset or liability is recognized only if it meets the definition of an asset or liability Financial Accounting, 7e Stice/Stice, 2006 © Thomson

BALANCE SHEET Definitions ASSET LIABILITY EQUITY Probable future economic benefit obtained or controlled by a particular entity as a result of past transactions or events Probable future sacrifice of economic benefit arising from a present obligation of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events Definitions EQUITY Residual interest in the assets of an entity that remains after deducting its liabilities Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Valuation Valuation is the process of assigning a value to an item once it is determined it should be recognized in the financial statements The value should be Reliable: Independent parties can agree on the value and Relevant: Reflects information that financial statement users care about Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Valuation Historical cost is an extremely reliable number Market value is an extremely relevant number The balance sheet reflects a mixture of different valuation methods Market value is used when it is both relevant and reliable, e.g., investment securities Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Recognition And Valuation Reflecting economic events in financial statements CREATION Events create economic assets and liabilities RECOGNITION Decision to include an item in the financial statements VALUATION Measurement of the dollar amount at which an item should be recorded INTEGRATION Determination of the total impact of the new information on the financial statements PREPARATION The financial statements themselves are prepared Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Introduction to Transaction Analysis

Assets = Liabilities + Owners Equity Transaction Analysis The process of determining how an economic event impacts the financial statements A spreadsheet can be used to analyze the transactions of Veda Landscape Solutions based on the accounting equation: Assets = Liabilities + Owners Equity Financial Accounting, 7e Stice/Stice, 2006 © Thomson

1) Veda invests $700,000 of her own cash in the business in exchange for all 10,000 shares of common stock. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

2) Borrowed $300,000 cash from Upland State Bank by signing a 10% note to be repaid in five years; interest is payable each January 1. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

3) Purchased a warehouse complex for $450,000 ($50,000 was for land) by paying $100,000 down and assuming a $350,000 mortgage. 8% interest is payable each January 1; balance due in a 7 year balloon payment Financial Accounting, 7e Stice/Stice, 2006 © Thomson

4) Purchased equipment for $650,000 cash. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

5) Hired 13 employees who will be paid each month for a total of $500,000 per year (no work has been done yet). Financial Accounting, 7e Stice/Stice, 2006 © Thomson

6). Leased a truck. The purchase cost would have been $65,000 6) Leased a truck. The purchase cost would have been $65,000. Lease payments are $800 a month for three years, after which the truck will be returned to the leasing company. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

7). Purchased inventory for $90,000 7) Purchased inventory for $90,000. Veda paid $10,000 cash and the balance was placed on account. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

8) Paid $15,000 in advance for a general insurance policy that is good for one year. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Assets = Liabilities + Equity Total assets $1,430,000 Total liabil & equity $1,430,000 Use this information to prepare the balance sheet Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Veda Landscape Solutions Balance Sheet January 1, 2006 Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Asset and Financing Mix

Asset and Financing Mix Asset mix is the proportion of total assets in each asset category Generally differs by industry Retailers have lots of inventory Manufacturers have lots of PP&E Banks have lots of loans receivable Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Asset and Financing Mix Financing mix is the percentage of financing in each of two categories: Liabilities Equity It is reflective of management financing decisions rather than industry Financial Accounting, 7e Stice/Stice, 2006 © Thomson

In Summary ... The impact of a business event on the company’s financial statements is determined through critical and systematic analysis of that event Assets and liabilities are classified as current and long-term; equity consists of paid-in capital and retained earnings. Treasury stock and other accumulated comprehensive income are part of equity. Recognition and valuation both require professional judgment Assets = Liabilities + Owners’ Equity Financial Accounting, 7e Stice/Stice, 2006 © Thomson