1. The Balance Sheet and Financial Disclosures
Chapter 3
Chapter 3: The Balance Sheet and Financial Disclosures
Chapter 1 stressed the importance of financial statements in helping investors and creditors predict future cash flows. The balance sheet, along with accompanying disclosures, provides relevant information useful in helping investors and creditors not only to predict future cash flows, but also to make the related assessments of liquidity and long-term solvency.
The purpose of this chapter is to provide an overview of the balance sheet and financial disclosures and to explore how this information is used by decision makers.

2. Reports a company’s financial position on a particular date.
The Balance Sheet
Reports a company’s financial position on a particular date.
Limitations:
The balance sheet does not portray the market value of the entity as a going concern nor its liquidation value.
Resources such as employee skills and reputation are not recorded in the balance sheet.
Usefulness:
The balance sheet describes many of the resources a company has for generating future cash flows.
It provides liquidity information useful in assessing a company’s ability to pay its current obligations.
It provides long-term solvency information relating to the riskiness of a company with regard to the amount of liabilities in its capital structure.
The purpose of the balance sheet, sometimes referred to as the statement of financial position, is to report a company’s financial position on a particular date. It is a freeze-frame or snapshot of financial position at the end of a particular day marking the end of an accounting period.
A limitation of the balance sheet is that assets minus liabilities, measured according to GAAP, is not likely to be representative of the market value of the entity. Many assets, like land and buildings, are measured at their historical costs rather than their market values. Relatedly, many company resources including its trained employees, its experienced management team, and its reputation are not recorded as assets at all.
However, despite these limitations, the balance sheet does have significant value. The balance sheet provides information useful for assessing future cash flows, liquidity (refers to the period of time before an asset is converted to cash or until a liability is paid), and long-term solvency (a company’s risk with regard to the amount of liabilities in its capital structure).

3. Classifications Liabilities Shareholders’ Equity Assets
The three primary elements of the balance sheet are assets (probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events), liabilities (probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events) and shareholders’ equity (the residual interest in the assets of an entity that remains after deducting liabilities). A distinction made in the balance sheet is the current versus noncurrent classification of both assets and liabilities.
Shareholders’ Equity
Assets

4. Current Assets Cash Cash Equivalents Short-term Investments
Receivables
Inventories
Prepaid Expenses
Current Assets
Will be converted to cash or consumed within one year or the operating cycle, whichever is longer.
Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills.
Current assets include cash and all other assets expected to become cash or consumed within one year or the operating cycle, whichever is longer. Current assets include cash, cash equivalents, short-term investments, receivables, inventories, and prepaid expenses.
Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. Cash that is restricted for a special purpose and not available for current operations should not be classified as a current asset.
Investments are classified as current if management has the ability and the intent to liquidate the investment in the near term.
Accounts receivable result from the sale of goods or services on credit. Accounts receivable and financing receivables are valued net, that is, less an allowance for uncollectible accounts (the amount not expected to be collected).
Inventories consist of assets that a retail or wholesale company acquires for resale or goods that manufacturers produce for sale.
Prepaid expenses represent an asset recorded when an expense is paid in advance, creating benefits beyond the current period. Examples are prepaid rent and prepaid insurance.

5. Operating Cycle of a Typical Manufacturing Company
Use cash to acquire raw materials 1
Convert raw materials to finished product 2
The operating cycle for a typical manufacturing company refers to the period of time necessary to convert cash to raw materials, raw materials to a finished product, the finished product to receivables, and then finally receivables back to cash.
In some businesses, such as shipbuilding or distilleries, the operating cycle extends far beyond one year. For most businesses, the operating cycle will be shorter than one year. In these situations the one-year convention is used to classify both assets and liabilities. Where a company has no clearly defined operating cycle, the one-year convention is used.
Deliver product to customer 3
Collect cash from customer 4

6. Noncurrent Assets Investments Property, Plant, & Equipment
Intangible Assets
Other Assets
Noncurrent Assets
Not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer.
Noncurrent assets include investments; property, plant, and equipment; intangible assets; and other long-term assets. Noncurrent assets are not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer.

7. Property, Plant, and Equipment
Noncurrent Assets
Intangible Assets
Used in the operations of the business but have no physical substance.
Include patents, copyrights, and franchises.
Reported net of accumulated amortization.
Investments
Not used in the operations of the business.
Include both debt and equity securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes.
Property, Plant, and Equipment
Are tangible, long-lived, and used in the operations of the business.
Include land, buildings, equipment, machinery, and furniture as well as natural resources such as mineral mines, timber tracts, and oil wells.
Reported at original cost less accumulated depreciation (or depletion for natural resources), except for land which is not depreciated.
Other Assets
Include long-term prepaid expenses and any noncurrent assets not falling in to one of the other classifications.
Investments are nonoperating assets not used directly in operations. This category includes both debt and equity securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes.
Tangible, long-lived assets used in the operations of the business are classified as property, plant, and equipment. This category includes land, buildings, equipment, machinery, and furniture as well as natural resources such as mineral mines, timber tracts, and oil wells. These items are reported at original cost less accumulated depreciation (or depletion for natural resources). Land is not depreciated, and therefore is recorded at original cost.
Intangible assets generally represent exclusive rights that a company can use to generate future revenues. This category includes patents, copyrights, and franchises. These items are reported net of accumulated amortization.
Balance sheets often include a catchall classification of noncurrent assets called other assets. This category includes long-term prepaid expenses and any noncurrent assets not falling in to one of the other classifications.

8. Current Liabilities Accounts Payable Notes Payable Accrued Liabilities
Unearned Revenues
Current Maturities of Long-Term Debt
Current Liabilities
Obligations expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer.
Current liabilities are expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer. Current liabilities include accounts payable, notes payable, accrued liabilities, unearned revenues, and current maturities of long-term debt.
Accounts payable are obligations to suppliers of merchandise or of services purchased on account, with payment usually due in 30 to 60 days.
Notes payable are written promises to pay cash at some future date. Unlike accounts payable, notes payable usually require the payment of explicit interest in addition to the original obligation amount. Notes maturing in the next year or operating cycle, whichever is longer, will be classified as current liabilities.
Accrued liabilities represent obligations created when expenses have been incurred but will not be paid until a subsequent reporting period.
Unearned revenues, sometimes called deferred revenues as in Google’s balance sheet, represent cash received from a customer for goods or services to be provided in a future period.
When long-term debt is payable in installments, the installment payable in the next year or operating cycle, whichever is longer, is reported as a current liability under the caption, “Current Maturities of Long-Term Debt.”

9. Long-Term Liabilities
Long-term Notes
Mortgages
Long-term Bonds
Pension Obligations
Lease Obligations
Long-Term Liabilities
Obligations that will not be satisfied within one year or the operating cycle, whichever is longer.
Long-term liabilities are not expected to be satisfied through current assets or creation of current liabilities within one year or the operating cycle, whichever is longer. Long-term liabilities include long-term notes, mortgages, long-term bonds, pension obligations, and lease obligations.

10. Equity is simply a residual amount derived from subtracting liabilities from assets. For this reason, it’s sometimes referred to as net assets. Shareholders’ equity for a corporation arises primarily from two sources: paid-in capital (shareholder invested capital) and retained earnings (amounts earned by the corporation). Paid-in capital is represented by preferred and common stock, which represent cash invested by shareholders in exchange for ownership interests. Retained earnings represents the accumulated net income earned since the inception of the corporation and not (yet) paid to shareholders as dividends. In addition to paid-in capital and retained earnings, shareholders’ equity may include a few other equity components, such as accumulated other comprehensive income (loss), which we will learn more about in later chapters.
Shareholders’ equity is the residual interest in the assets of an entity that remains after deducting liabilities.

11. Summary of Significant Accounting Policies
Disclosure Notes
Summary of Significant Accounting Policies
Conveys valuable information about the company’s choices from among various alternative accounting methods.
Subsequent Events
A significant development that occurs after the company’s fiscal year-end but before the financial statements are issued or available to be issued.
The full-disclosure principle requires that financial statements provide all material and relevant information concerning the reporting entity. Disclosure notes typically span several pages and either explain or elaborate upon the data presented in the financial statements themselves, or provide information not directly related to any specific item in the statements. Disclosure notes must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions.
The summary of significant accounting policies conveys valuable information about the company’s choices from among various alternative accounting methods. For example, management chooses whether to use accelerated or straight-line depreciation and whether to use first-in, first-out; last-in, first-out; or weighted average to measure inventories. Typically, this first disclosure note consists of a summary of significant accounting policies that discloses the choices the company makes.
A subsequent event is a significant development that occurs after the company’s fiscal year-end but before the financial statements are issued or available to be issued. Examples include the issuance of debt or equity securities, a business combination or the sale of a business, the sale of assets, an event that sheds light on the outcome of a loss contingency, or any other event having a material effect on operations.
Some transactions and events occur only occasionally, but when they do occur they are potentially important to evaluating a company’s financial statements. In this category are related-party transactions, errors and irregularities, and illegal acts.
Noteworthy Events and Transactions
Transactions or events that are potentially important to evaluating a company’s financial statements, e.g., related-party transactions, errors and irregularities, and illegal acts.

12. Management Discussion and Analysis
Provides a biased but informed perspective of a company’s operations, liquidity, and capital resources.
Each annual report of a public company requires a fairly lengthy discussion and analysis provided by the company’s management. In this section, management provides its views on significant events, trends, and uncertainties pertaining to the company’s operations, liquidity, and capital resources.
The Management Discussion and Analysis (MDA) section of an annual report relates management’s biased perspective. However, it can also offer an informed insight that might not be available elsewhere.

13. Management’s Responsibilities
Preparing the financial statements and other information in the annual report.
Maintaining and assessing the company’s internal control procedures.
Management prepares and is responsible for the financial statements and other information in the annual report. Annual reports include a management’s responsibility section that asserts the responsibility of management for the information contained in the annual report as well as an assessment of the company’s internal control procedures.

14. Auditors’ Report
Expresses the auditors’ opinion as to the fairness of presentation of the financial statements in conformity with generally accepted accounting principles.
Auditors examine financial statements and the internal control procedures designed to support the content of those statements. Their role is to attest to the fairness of the financial statements based on that examination. The auditors’ attest function results in an opinion stated in the auditors’ report.
The auditors’ report provides an independent and professional opinion about the fairness of the representation in the financial statements and about the effectiveness of internal controls. Every audit report looks similar because it must comply with specifications of the Public Companies Accounting Oversight Board (PCAOB).
The auditors’ report must comply with specifications of the Public Companies Accounting Oversight Board (PCAOB).

15. Auditors’ Opinions Unqualified Qualified Adverse Disclaimer
Issued when the financial statements present fairly the financial position, results of operations, and cash flows and are in conformity with U.S. GAAP.
Qualified
Issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole.
Adverse
Issued when the exceptions are so serious that a qualified opinion is not justified.
There are four types of audit opinions. An unqualified opinion is issued when the financial statements present fairly the financial position, results of operations, and cash flows and are in conformity with U.S. GAAP. Sometimes, circumstances cause the auditors’ report to include an explanatory paragraph in addition to the standard wording, even though the report is unqualified. Most notably, these include: lack of consistency due to a change in accounting principles, uncertainty as to the ultimate resolution of a contingency, and emphasis of a matter concerning the financial statements. Other times an unqualified opinion is not appropriate due to exceptions including nonconformity with U.S. GAAP, inadequate disclosures, and a limitation or restriction of the scope of the examination.
A qualified opinion is issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole.
An adverse opinion is issued when the exceptions are so serious that a qualified opinion is not justified. Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report.
A disclaimer opinion is issued when insufficient information has been gathered to express an opinion.
Disclaimer
Issued when insufficient information has been gathered to express an opinion.

16. Using Financial Statement Information
Comparative Financial Statements
Allow financial statement users to compare year-to-year financial position, results of operations, and cash flows.
Horizontal Analysis
Expresses each item in the financial statements as a percentage of that same item in the financial statements of another year (base amount).
Vertical Analysis
Involves expressing each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, within the same year.
Investors, creditors, and others use information that companies provide in corporate financial reports to make decisions. Comparative financial statements allow financial statement users to compare year-to-year financial position, results of operations, and cash flows.
Some analysts enhance their comparison by using horizontal analysis. Horizontal analysis expresses each item in the financial statements as a percentage of that same item in the financial statements of another year (base amount).
Similarly, vertical analysis involves expressing each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, but within the same year. For example, cash inventory, and other assets can be restated as a percentage of total assets; net income and each expense can be restated as a percentage of net revenues.
No accounting numbers are meaningful in and of themselves. Ratio analysis allows analysts to control for size differences over time and among firms.
Ratio Analysis
Allows analysts to control for size differences over time and among firms.

17. Measures a company’s ability to satisfy its short-term liabilities
Liquidity Ratios =
Current ratio
Current assets
Current liabilities
Measures a company’s ability to satisfy its short-term liabilities =
Acid-test ratio
Quick assets
Current liabilities
Provides a more stringent indication of a company’s ability to pay its current liabilities
Liquidity refers to the readiness of assets to be converted to cash. Liquidity ratios compare a company’s obligations that will shortly become due with the company’s cash and other current assets that, by definition, are expected to be used to pay for the obligations that will be due in the short term.
The current ratio is calculated as current assets divided by current liabilities and measures a company’s ability to satisfy its short-term liabilities. A current ratio of 2 indicates that the company has twice as many current assets available as current liabilities. A company could have difficulty paying its liabilities even with a current ratio significantly greater than For example, a large portion of the current assets could include inventory. If the inventory is not able to be converted into cash for several months, obligations may come due that could not be paid out of current assets.
The acid-test ratio is calculated as quick assets divided by current liabilities. Quick assets are current assets excluding inventories and prepaid items. By eliminating current assets less readily convertible into cash, this ratio provides a more stringent indication of a company’s ability to pay its current liabilities.

18. Financing Ratios Total liabilities Debt to equity ratio=
Debt to equity ratio
Total liabilities
Shareholders’ equity
Indicates the extent of reliance on creditors, rather than owners, in providing resources =
Times interest earned ratio
Net income + Interest expense + Income taxes
Interest expense
Indicates the margin of safety provided to creditors
Investors and creditors, particularly long-term creditors, are vitally interested in a company’s long-term solvency and stability. The debt to equity ratio is calculated as total liabilities divided by shareholders’ equity. This ratio indicates the extent of reliance on creditors, rather than owners, in providing resources. The higher this ratio, the greater the creditor claims on assets, so the higher the likelihood an individual creditor would not be paid in full if the company is unable to meet its obligations.
The times interest earned ratio is a way to gauge the ability of a company to satisfy its fixed debt obligations by comparing interest charges with the income available to pay those charges. This ratio is calculated as net income plus interest expense plus income taxes divided by interest expense. The times interest earned ratio indicates the margin of safety provided to creditors.

19. Appendix 3: Reporting Segment Information
Many companies operate in several business segments as a strategy to achieve growth and to reduce operating risk through diversification.
Segment reporting facilitates the financial statement analysis of diversified companies.
Reportable Operating Segment Characteristics
Appendix 3: Reporting Segment Information
Many companies operate in several business segments as a strategy to achieve growth and to reduce operating risk through diversification. Segment reporting facilitates the financial statement analysis of diversified companies.
The following characteristics define an operating segment. An operating segment is a component of an enterprise:
That engages in business activities from which it may earn revenues and incur expenses.
Whose operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance.
For which discrete financial information is available.
Engages in business activities from which it may earn revenues and incur expenses.
Operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance.
Discrete financial information is available.

20. End of Chapter 3
End of Chapter 3.