COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. The Balance Sheet and Notes to the Financial Statements Chapter 3 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

Learning Objectives 1.Describe the specific element of the balance sheet (assets, liabilities, and owners’ equity), and prepare a balance sheet with assets and liabilities properly classified into current and noncurrent categories. 2.Identify the different formats used to present balance sheet data. 3.Analyze a company’s performance and financial position through the computation of financial ratios.

Learning Objectives (cont.) 4.Recognize the importance of the notes to the financial statements and outlined the types of disclosures made in the notes. 5.Understand the major limitations of the balance sheet. Problems to work using ThomsonNow: Prob 37, 38, 40, 43

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The Balance Sheet Presents a listing of an organization’s assets and liabilities at a certain time point. The difference between assets and liabilities is called equity. Represented by the basic accounting equation: Assets = Liabilities + Owners’ Equity

Assets Resources owned or controlled by an entity; costs expected to provide future economic benefit. Assets Elements of the Balance Sheet compare to exhibit 3-2 The primary purpose of the balance sheet is to help forecast the future.

Elements of the Balance Sheet “Obligation” includes legal, moral, social, and implied commitments. An obligation to provide services is also a liability. Assets and liabilities arise from past events. Liability Claims of creditors against the entity resources; probable future economic resources Liability Claims of creditors against the entity resources; probable future economic resources

Elements of the Balance Sheet The amount of total assets which are claimed by the owners The net assets of an entity Is effected by investment by owners, net income or loss, distributions to owners Owner’s Equity The interest of the ownership group in an entity’s total resources Owner’s Equity The interest of the ownership group in an entity’s total resources

How to Classify Items on the Balance Sheet—exhib 3-3 Current (less than 1 year) Noncurrent (more than 1 year) Order of liquidity Historical cost Working capital = CA - CL It is the liquid buffer available in meeting financial demands and contingencies of the near future.

Current Assets Cash and resources expected to be converted to cash during the entity’s normal operating cycle or one year, whichever is longer, are current assets. Cash Trading Securities Accounts Receivables Inventories Prepaid Assets

Operating Cycle Receivables Cash Inventories Purchases Collections Sales

Noncurrent Assets Investments Property, plant, and equipment Intangible Assets Deferred income taxes

Current liabilities are obligations expected to be paid using current assets or by creating other current liabilities. Accounts and notes payable Accrued expenses Current portion of long-term obligations Unearned revenues Generally, if a liability is expected to be paid within 12 months, it is classified as current as long as it is paid within the operating cycle. Current Liabilities

If the terms of the agreement for a callable obligation is due on demand or will become due on demand within one year from the balance sheet date, the obligation should be classified as current. Callable Obligations

Noncurrent Liabilities Current liabilities do not usually include: –Debts to be liquidated from a noncurrent sinking fund. Sinking fund- cash and investment securities that have been accumulated for payment of a specific loan. –Short-term obligations to be refinanced.

Noncurrent Liabilities Long-term debt Long-term lease obligations Deferred income tax liability Pension obligations

Noncurrent Liabilities Long-term debt is reported at its discounted present value. When a note, bond issue, or a mortgage becomes payable within a year, it should be reclassified as a current liability. For a capital lease, the present value of the future minimum payments is recorded as long-term liability. Most large companies include deferred taxes liabilities on the balance sheet.

Contingent Liabilities Presently “not real” liability but may become a liability depending on the occurrence of a future event.

Contingent Liabilities Past activities or circumstances may give rise to possible future liabilities. Contingent liabilities- Potential obligations that do not exist on the balance sheet date. Uncertainty as to whether future events will or will not occur If “probable” a loss/liability will be recognized If only “possible” only disclosure is given If “remote” no action needs to be taken An estimated liability is a definite liability, so it is not a contingent liability.

Estimated Liabilities Future certainty exists, but relative amount and timing is questionable Examples: –Pensions –Warranties –Deferred taxes –Environmental cleanup Estimate $$$ amount should be shown on the Balance Sheet

Owners’ Equity Can also be called stockholders’ or shareholders equity. Generally divided into two parts: 1.Contributed capital also known as paid- in-capital 2.Retained Earnings

Contributed Capital Two parts of contributed capital: 1.Capital Stock- the number of shares x the par value. a.Preferred stock- usually paid a fixed annual cash dividend and have rights to their investment in bankruptcy b.Common stock- real owners of the corporation, have voting power, but are last in line for assets in bankruptcy 2.Additional paid-in capital- investment by shareholders in excess of par value of capital stock.

Retained Earnings Retained Earnings (RE)- the amount of undistributed earnings of past periods. RE Deficit- an excess of dividends and losses over earnings results in a negative retained earnings balance. Sometimes, RE is restricted and unavailable for cash dividends.

Treasury Stock Treasury Stock- when a company buys back its own shares. Treasury shares can be retired, or they can be retained and reissued later. X Corporation Common Stock Par $10

Other Equity “Other Comprehensive Income” The FASB requires companies to summarize changes in owners’ equity exclusive of net income and contributions by and distributions to owners. Unrealized gains and losses on available-for-sale securities are shown as a separate equity item. These are shown at their market value. Adjustments arising from the change in the equity of foreign subsidiaries (as measured in U.S. dollars) resulting from changes in foreign currency exchange rates are shown in the equity section. Some of the unrealized gains and losses from the fluctuations in the value of derivatives are reported as part of accumulated other comprehensive income.

Format of the Balance Sheet Generally, assets and liabilities are presented in their order of liquidity. Some industries with significant investments in land and buildings will list these items first on the balance sheet. Generally, a balance sheet is presented in comparative form, including data from both the current year and the previous year. Foreign balance sheets frequently list the current assets and current liabilities together. Compare exhibits 3-6 to 3-7 Samples on my Homepage: Projected; with Ratios; Basic1; Basic2Projectedwith RatiosBasic1Basic2

Balance Sheet Analysis Balance sheet information is analyzed two ways: 1.Relationships between balance sheet amounts 2.Relationships between balance sheet and income statement amounts. Financial ratios show the relationships between financial statement amounts.

Liquidity Liquidity - the ability of a firm to satisfy its short-term obligations. Two common measures of liquidity: 1.Current ratio = Current Assets Current Liabilities 2. Quick ratio = Quick Assets Current Liabilities What are the “quick assets?” cash + investment securities + net receivables

Cash $ 30 Net Accounts Receivable 70 Inventory 100 Current Assets$200 Current Liabilities100 Cash $ 30 Net Accounts Receivable 70 Inventory 100 Current Assets$200 Current Liabilities100 Current Assets Current Liabilities Current Assets Current Liabilities $200$100$200$100 = 2:1 Current Ratio Liquidity Ratio Example

Cash $ 30 Net Accounts Receivable 70 Inventory 100 Current Assets$200 Current Liabilities100 Cash $ 30 Net Accounts Receivable 70 Inventory 100 Current Assets$200 Current Liabilities100 Quick Assets Current Liabilities Quick Assets Current Liabilities $100$100$100$100 = 1:1 Cash $ 30 Net Accounts Receivable 70 Inventory 100 Current Assets$200 Current Liabilities100 Cash $ 30 Net Accounts Receivable 70 Inventory 100 Current Assets$200 Current Liabilities100 Quick Ratio Liquidity Ratio Example

Leverage What is Leverage? compares liabilities to assets to determine the extent to which borrowed funds are used to “leverage the owners investments to increase the business” referred to as the “debt ratio” shows the overall ability of the company to repay its debts

Overall Leverage Debt Ratio - total liabilities divided by total assets. Total Assets$400 Total Liabilities300 Debt Ratio - total liabilities divided by total assets. Total Assets$400 Total Liabilities300 Total Liabilities Total Assets Total Liabilities Total Assets $300$400$300$400 = 75%

Efficiency Asset Turnover- measures how efficiently a company uses its assets to generate sales. Sales$200 Total Assets400 Asset Turnover- measures how efficiently a company uses its assets to generate sales. Sales$200 Total Assets400 Sales Total Assets Sales $200$400$200$400 = 0.50 Other similar turnover ratios are— accounts receivable, inventory, fixed assets

Profitability Net Income$ 40 Total Assets400 Stockholders’ Equity160 Net Income$ 40 Total Assets400 Stockholders’ Equity160 Net Income Total Assets Net Income Total Assets $40$400$40$400 = 10.0% Return on Assets Two ratios that measure profitability: 1.Return on Assets--ROA 2.Return on Equity--ROI Two ratios that measure profitability: 1.Return on Assets--ROA 2.Return on Equity--ROI Compares Net Income to some measure of the size of the investment.

Profitability Net Income$ 40 Total Assets400 Stockholders’ Equity160 Net Income$ 40 Total Assets400 Stockholders’ Equity160 Net Income Total Assets Net Income Total Assets $40$160$40$160 =.25% Return on Equity Two ratios that measure profitability: 1.Return on Assets 2.Return on Equity Two ratios that measure profitability: 1.Return on Assets 2.Return on Equity

Selected 2004 Ratios

Typical Notes to the Financial Statements The financial statements do not provide all of the information desired by users. Other useful information includes:

Typical Notes to the Financial Statements Summary of significant accounting policies, i.e. methods related to depreciation, inventory valuation, accounting changes, and revenue recognition. Additional information to support summary totals. Information that fails to meet recognition criteria for statements, but is important for users. Supplementary information required by the FASB or SEC to adhere to full disclosure principle.

Subsequent Events occur after the Balance Sheet date, but before the financial statements

Subsequent Events Financial Statement Period Events in this period may affect the reporting of events in this period. Balance Sheet Date Date Statements Issued Subsequent Period

Subsequent Events Financial Statement Period Subsequent Period Balance Sheet Date Date Statements Issued Types of Events: Ones that materially affect one or more financial statements. Ones that create a need for a footnote.