The Balance Sheet and the Statement of Changes in Stockholders’ Equity C hapter 4 COPYRIGHT © 2010 South-Western/Cengage Learning Intermediate Accounting 11th edition Nikolai Bazley Jones An electronic presentation By Norman Sunderman and Kenneth Buchanan Angelo State University

Objectives 1.Understand the purposes of the balance sheet. 2.Define the elements of a balance sheet. 3.Explain how to measure (value) the elements of a balance sheet. 4.Classify the assets of a balance sheet. 5.Classify the liabilities of a balance sheet. 2

Objectives 6.Report the stockholders’ equity of a balance sheet. 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. 3

FASB Statement of Concepts No. 5 4 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 5

Interrelationship of Financial Statements 6

Basic Accounting Equation 7 Assets = Liabilities + Stockholders’ Equity Economic resources Economic obligations Net assets

Liquidity 8 The term liquidity is used to describe how quickly an asset can be converted into cash or a liability paid.

Financial Flexibility 9 Financial flexibility refers to the ability of a company to use its financial resources to adapt to change.

Operating Capability 10 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 11

Elements of the Balance Sheet: Assets 12 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. 13

14 Assets may be natural or man-made, tangible or intangible, and either exchangeable or useful only in the company’s activities. Elements of the Balance Sheet: Assets Simply, assets have future value.

Elements of the Balance Sheet: Liabilities 15 Liabilities are probable future sacrifices of economic benefits arising from present obligations...

Elements of the Balance Sheet: Liabilities 16 …of a company to transfer assets or provide services in the future as a result of past transactions or events.

Elements of the Balance Sheet: Stockholders’ Equity 17 Assets = Liabilities + Stockholders’ Equity Equity is the residual interest in the assets of a company that remains after deducting its liabilities.

Measurement (Valuation) of the Elements of the Balance Sheet 18 Historical Cost Fair Value Present Value

19 Historical cost is the exchange price in the transaction in which an asset was acquired. Fair value is the price that a company would receive to sell an asset (or transfer a liability) in an orderly transaction between market participants on the date of measurement. Measurement (Valuation) of the Elements of the Balance Sheet The present value of an asset is the net amount of discounted future cash inflows less the discounted future cash outflows relating to the asset.

20 Fair Value Measurement Need Fair Value Select Highest Appropriate Level of Input for Valuation (Hierarchy of Valuation Methods)  Level 1: Quoted Price for Identical Asset (or Liability) in Active Market  Level 2: Adjusted Quoted Price (Exit Value) for Similar Asset (or Liability)  Level 3: Unobservable Inputs (e.g., Present Value of Expected Cash Flows) Select Highest Appropriate Level of Input for Valuation (Hierarchy of Valuation Methods)  Level 1: Quoted Price for Identical Asset (or Liability) in Active Market  Level 2: Adjusted Quoted Price (Exit Value) for Similar Asset (or Liability)  Level 3: Unobservable Inputs (e.g., Present Value of Expected Cash Flows)

21 Fair Value Measurement Measure Best Fair Value Use Valuation Method Consistent with  Market Approach (Identical or Comparable Assets or Liabilities)  Income Approach (Present Value)  Cost Approach (Replacement Cost) Use Valuation Method Consistent with  Market Approach (Identical or Comparable Assets or Liabilities)  Income Approach (Present Value)  Cost Approach (Replacement Cost)

22 Fair Value Measurement Disclosures  GAAP requires the company to segregate its fair value measurements into those based on Level 1, 2, and 3 inputs.  For Level 3 measurements, the company must also include the valuation technique used

Limitations of the Balance Sheet  The use of historical cost to value assets and liabilities does not help users assess the likely amounts of future cash flows.  “Human resources” 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, some amounts listed do not show the “purchasing power” of assets and liabilities. 23

Current Assets 24 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 25 An operating cycle is the average time taken by a company to spend cash for inventory,...

26 …process and sell the inventory, and collect the receivables, converting them back into cash. Operating Cycle

27 Operating Cycle Flow

28 Current Assets 1.Cash (and cash equivalents) 2.Temporary investments in marketable securities 3.Receivables (accounts and notes with short-term maturity dates) 4.Inventories 5.Prepaid items 1.Cash (and cash equivalents) 2.Temporary investments in marketable securities 3.Receivables (accounts and notes with short-term maturity dates) 4.Inventories 5.Prepaid items

29 Current Assets Cash includes cash on hand and readily available in checking and savings accounts. 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.

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

31 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 work in process inventories. Prepaid items such as insurance, rent, office supplies, and taxes will not be converted into cash but will be consumed. Current Assets

Current Liabilities 32 Current liabilities are obligations of a company that it expects to liquidate by using current assets, or creating other current liabilities within one year or the normal operating cycle, whichever is longer.

Current Liabilities 33 1.Obligations for items are in the operating cycle (accounts payable and salaries payable). 2.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 (the estimated liability for short-term product warranties).

Current Liabilities Examples 34  Trade payables from the purchase of goods for resale  Short-term notes payable  Current maturities of long-term liabilities  Unearned revenues (collections received in advance for the delivery of goods or the performance of services such as unearned legal fees, prepaid rent income, and prepaid subscriptions)  Accrued expenses  Current portion of deferred income tax liabilities  NSF checks  Accounts receivable with credit balances

35 Working Capital Current Assets – Current Liabilities = Working Capital

Long-Term Investments 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 expansion. 36 A company makes investments for several reasons:

Long-Term Investments 37 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.

Property, Plant, and Equipment 38 Property, plant, and equipment includes the tangible assets used in the firm’s operations. Also called fixed assets

Property, Plant, and Equipment 39  Land  Buildings  Equipment  Machinery  Furniture  Natural resources

Intangible Assets 40 Intangible assets are those noncurrent economic resources that a company uses in its operations but have no physical existence. Patents Copyrights Franchises

Intangible Assets 41 Intangible assets are those noncurrent economic resources that a company uses in its operations but have no physical existence. Trademarks ® a registered trademark Computer software costs Goodwill

42 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

43 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 44 Long-term liabilities are those obligations of a company whose liquidation is 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 45 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  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 the fair value method used to value the items. 46 FASB suggested guidelines for developing homogeneous classes of assets and liabilities.

Stockholders’ Equity 47 Stockholders’ equity is the residual interest of the stockholders in the assets of the corporation. A sole proprietorship is a single-owner company.

Stockholders’ Equity 48 Stockholders’ equity is the residual interest of the stockholders in the assets of the corporation. A partnership involves two or more persons who have agreed to combine their capital and efforts in the operations of a company.

Stockholders’ Equity 49 Stockholders’ equity is the residual interest of the stockholders in the assets of the corporation. The corporation is a complex business organization. Usually there is absentee ownership.

Stockholders’ Equity Contributed capital Retained earnings Accumulated other comprehensive income 50 Components of Stockholders’ Equity

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

52 Stockholders’ Equity A corporation sells 100 shares of its $5 par common stock for $30 per share. Cash3,000 Common Stock, $5 par500 Additional Paid-in Capital on Common Stock2,500 Contributed Capital

53 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 fair 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 plan gains, losses, and prior service cost adjustments. 54 Comprehensive income includes both net income and “other comprehensive income.” Accumulated other comprehensive income might include four items:

55 Stockholders’ Equity A company is required to report its total comprehensive income for the accounting period.

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

57 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 58 A corporation must disclose the changes in its stockholders’ equity account when issuing financial statements. This statement should show, among other information, investments by and distributions to owners during the period.

59 Statement of Changes in Stockholders’ Equity FASB Statement of Concepts No. 6 defines 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 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.

60 Statement of Changes in Stockholders’ Equity

Summary of Accounting Policies A selection from existing acceptable alternatives Principles and methods peculiar to the industry in which the company operates Unusual or innovative applications of GAAP 61 GAAP requires that a company must include a description of all its significant accounting policies as an integral part of its financial statements. In particular, when these principles and methods involve:

62 Accounting for Loss Contingencies Loss Probable? Reasonably estimated? No or Disclosure and Yes Report amount in financial statements Reasonably possible Disclose in notes to the financial statements

Subsequent Events 63 A subsequent event is one that occurs between a company’s 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 64 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 60 days of its fiscal year-end. This report must be filed electronically according to the EDGAR requirements. ContinuedContinued

65 SEC Integrated Disclosures The SEC requires comparative balance sheets for 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.

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

67 SEC Integrated Disclosures Several disclosures must be made about the common stock 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

68 IFRS vs. U.S. GAAP  The financial statements required by the International Accounting Standards Board (IASB) are similar to those in the United States.  Unlike U.S. GAAP, in which a company typically presents either a classified or nonclassified balance sheet, International Financial Reporting Standards (IFRS) do not require a particular format; the appropriate format depends on the type of company.

69 IFRS vs. U.S. GAAP  IFRS do require that companies classify assets on the balance sheet as either noncurrent or current.  Noncurrent assets include property, plant, and equipment, as well as other items such as investments, long-term receivables, and intangibles.  Current assets are defined similarly to those under U.S. GAAP.  Typically, noncurrent assets are presented first, followed by current assets.

70 IFRS vs. U.S. GAAP  “Capital and reserves,” which includes issued capital (capital stock and additional paid-in capital), reserves, and accumulated profits or losses (retained earnings), is usually listed first.  Reserves may result from upward revaluations of properties and investments, as well as currency translation differences.  Noncurrent liabilities are usually listed next, followed by current liabilities.

Balance Sheet Formats 71 Most companies use the report form or the account form format in presenting their balance sheets.

72 Report Form Assets xxxx$xxx xxxx xxx Total assets$xxx Liabilities and Stockholders’ Equity xxxx$xxx xxxxxxx Total liabilities and stockholders’ equity$xxx Balance Sheet Formats

73 Liabilities and Stockholders’ Equity xxxx$xxx xxxxxxx Total liab. & stock. eq.$xxx Account Form Assets xxxx$xxx xxxxxxx Total assets$xxx Balance Sheet Formats

74 C hapter 4 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.