1. Chapter 3
Balance Sheet
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2. Forms of Business Entities
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3. The Balance Sheet “Statement of Financial Position”
Dated as of a specific date
Format
Account
Report
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4. Balance Sheet – Report Form
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5. Statement of Stockholders’ Equity
Balance Sheet
Income Statement
Revenue $ 120,000
Expenses (100,000)
Net Income $ 20,000
Statement of Stockholders’ Equity
Capt. Stk. Ret. Earn.
Beginning Balance $20,000 $ 5,000
Net income 20,000
Dividends (10,000)
Ending Balance $20,000 $ 15,000
Shows the financial condition of an entity as of a particular date
Assets: the resources of the business
Liabilities: the debts of the business
Equity: the owners’ interest in the business
The Accounting Equation: Assets =Liabilities + Stockholders’ Equity
Assets =Liabilities + Capital Stock + Retained Earnings
Balance Sheet
Assets $110,000
Liabilities 25,000
Stockholders’ Equity
Capital Stock 50,000
Retained Earnings ,000
$110,000
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6. Balance Sheet – Account Form
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7. Assets
Probable future economic benefits obtained or controlled by an entity as a result of past transactions or events
Current Assets
Long-Term Assets
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8. Current Assets
Cash and assets that will be converted into cash during the operating cycle or within a year, whichever is longer
Presented in order of liquidity
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9. Current Assets (cont’d)
Cash
Negotiable checks, unrestricted balance in checking accounts, savings accounts
Marketable Securities
Debt or equity securities
Carried at fair value
Intention to convert into cash during the current period
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10. Current Assets (cont’d)
Accounts Receivable
Amounts due from sales or services
Carried at net realizable value (net of allowances)
Other receivables due from nontrade sources
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11. Current Assets (cont’d)
Inventories
Carried at lower of cost or market
Categories
Goods on hand
Raw materials
Work in process
Finished goods
Manufacturer
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12. Current Assets (cont’d)
Prepaids
Expenditures made in advance of the use of the service or goods.
Examples
Insurance
Advertising
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13. Long-Term Assets: Tangible
Land
Carried at acquisition cost
Not subject to depreciation
Natural resources are depleted
Buildings
Cost plus permanent improvements
Depreciated over the useful life
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14. Long-Term Assets: Tangible (cont’d)
Machinery
Acquisition cost plus costs of delivery, installation, and permanent improvements
Depreciated over the useful life
Construction in Progress
Assets under construction
Transferred to permanent asset account upon completion
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15. Long-Term Assets: Tangible (cont’d)
Accumulated Depreciation
Carries the to-date depreciation of plant assets
Factors used in depreciation calculation
Asset cost
Length of the life of the asset
Estimated salvage (residual) value of asset when retired
Depreciation methods
Straight Line – Declining Balance
Sum-of-the-Years’-Digits – Units of Production
Balance sheet presentation
Cost of the asset
– Accumulated depreciation
= Net book value
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16. Depreciation: Straight-Line Method
Cost $10,000 Estimated salvage $2,000
Estimated life years
The salvage value is not depreciated.
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17. Depreciation: Declining-Balance Method
Cost $10,000 Estimated salvage $2,000
Estimated life years
Double the straight-line rate is the maximum rate
Scrap value is not used in the depreciation formula but depreciation ends when the book value is equal to the salvage value.
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18. Depreciation: Sum-of-the-Years’-Digits Method
Cost $10,000 Estimated salvage $2,000
Estimated life years
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19. Depreciation: Units-of-Production Method
Cost $10,000 Estimated salvage $2,000
Estimated total hours ,000
Hours of Operation × Rate = Depreciation
Asset is depreciated until salvage value is reached
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20. Long-Term Assets: Leases
Capital lease
In-substance ownership
Recorded as an asset net of amortization
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21. Long-Term Assets: Investments
Debt or equity securities
Held to maintain business relationship or to exercise control
Debt classification
Held-to-maturity carried at amortized cost
Available-for-sale carried at fair value
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22. Long-Term Assets: Investments (cont’d)
Equity securities
Carried at fair value
Exception: with the ability to exercise significant influence the equity method is used: cost is adjusted for the proportionate share of the rise/fall in the retained profits of the subsidiary (investee)
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23. Long-Term Assets: Intangibles
Goodwill
Purchase of a business where price paid exceeds the fair value of net assets
U.S. GAAP: not amortized; test annually for impairment
Patents
20 years
Amortized over shorter of legal or useful life
Trademarks
Indefinite legal life
Not amortized; test annually for impairment
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24. Long-Term Assets: Intangibles (cont’d)
Franchises
Life based on contract
Amortize over shorter of legal or useful life
Copyrights
Life of the creator plus 70 years
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25. 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 futures as a result of past transactions or events
Current Liabilities
Long-Term Liabilities
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26. Current Liabilities
Obligations whose liquidation is reasonably expected to
Require the use of
Existing current assets
Creation of other current liabilities
Within one year or the operating cycle, whichever is longer
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27. Current Liabilities (cont’d)
Payables
Short-term obligations created by the acquisition of goods or services
Unearned Income
Payments collected in advance of the performance of services or delivery of goods
Other current liabilities
As circumstances warrant
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28. Long-Term Liabilities
Due in a period beyond one year or operating cycle
Related to
Financing arrangements
Operational obligations
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29. Long-Term Liabilities: Financing Arrangements
Notes Payable
Secured by property: Mortgage notes
Credit Agreements
Ready lines of credit that may require a compensating balance
Not a liability until funds are drawn
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30. Long-Term Liabilities: Financing Arrangements (cont’d)--Thurs
Bonds Payable
Sold at par, premium, or discount
Premium or discount is amortized into interest expense
Bond carrying value is amortized to par value
Convertible bonds can be converted into common stock
Conversion feature enhances bond selling price
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31. Bonds at Par, Premium, or Discount
Market Interest Rate
Bonds Sold at 6%
Premium
Bond Contractual Interest Rate 8% 8%
Par (Face Value)
10%
Discount
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32. Long-Term Liabilities: Operational Obligations
Deferred Taxes
Difference between accounting and tax methods
Difference in the timing of recognizing revenue and expense for accounting and tax purposes
Warranty Obligations
Estimated; arise from offering product warranties
Estimated to achieve matching of sales revenue and associated expense of warranty
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33. Long-Term Liabilities: Operational Obligations (cont’d)
Minority Interest
Reported on consolidated financial statements
Represents the interest in the equity of a partially-held subsidiary by the nonmajority owners
Not a liability per se but for purposes of analysis treat as a liability
Other Noncurrent Liabilities
As circumstances warrant
Redeemable Preferred Stock
Excluded from stockholders’ equity
For analysis, treat as a liability
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34. Stockholders’ Equity
The residual ownership interest in the assets of an entity that remains after deducting its liabilities
Paid-in Capital
Retained Earnings
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35. Stockholders’ Equity: Paid-in Capital
Par value
In some states, referred to as “stated value”
Considered “legal capital” by many states
Established by the articles of incorporation
Usually a minimal value
No-par stock
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36. Stockholders’ Equity: Paid-in Capital (cont’d)
Additional paid-in capital
Issue price in excess of par (stated) value
Other sources
Treasury stock transactions
Stock dividend transactions
Donated capital
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37. Stockholders’ Equity: Paid-in Capital (cont’d)
Common Stock
Shareholder ownership
Voting rights
Election of board of directors
Major corporate decisions
Liquidation rights secondary to
Creditors
Preferred stock
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38. Stockholders’ Equity: Paid-in Capital (cont’d)
Preferred Stock
Does not normally convey voting rights
May carry any or all of these features:
Preference as to dividends
Accumulation of dividends
Participation in dividend beyond stated dividend rate
Convertibility into common stock at holder’s discretion
Preference in liquidation secondary to creditors
Callable at issuer discretion
Redemption at future maturity value
Donated Capital
Donated by outside entities
Shareholder surrender of stock
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39. Stockholders’ Equity: Retained Earnings
Undistributed earnings of the corporation
Net income for all prior periods
Less dividends declared to shareholders
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40. Stockholders’ Equity: Other
Quasi-Reorganization
Eliminates a deficit balance of retained earnings
Retained earnings are dated for 5-10 years
Equity-Oriented Deferred Compensation
A reduction to stockholders’ equity that is amortized (expensed) to future periods of employee service
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41. Stockholders’ Equity: Other (cont’d)
Employee Stock Ownership Plans (ESOPs)
A qualified pension plan
Tax benefits for the employer and employee
Unearned compensation reduces stockholders’ equity
Treasury Stock
Stock purchased and held by the issuing corporation
Recording and disclosure
Record at par value; deduct from paid-in capital
Record at cost; deduct from total stockholders’ equity
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42. Statement of Stockholders’ Equity
Reconciles the beginning and ending balances of all components of stockholders’ equity
Account changes indicate
Issuance of stock: paid-in capital increase
Acquisition of treasury stock: treasury stock increase
Net income: retained earnings increase
Dividends: retained earnings decrease
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43. Balance Sheet Presentation Issues
Financial analysis is complicated by
Many assets recorded at cost rather than fair (replacement) value
Varying valuation methods
Within a firm from item to item
Within an industry from company to company
Not all items of value are listed as assets
Certain contingent liabilities may be excluded
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44. Let’s analyze some transactions for JJ’s Lawn Care Service.
Let’s look at how specific business transactions impact the basic financial statement we just discussed.
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45. Recording Transactions
Internal or external event that causes a change in a company’s assets, liabilities, or stockholders’ equity
Recorded in a journal (journal entry)
Posted to general ledger accounts
Double-entry system
Debit: left side of an account
Credit: right side of an account
Debits = Credits
Account Title
Debit
Credit
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46. On May 1, 2005, Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service and received 800 shares of stock.
Part I On May first, Jill Jones and her family invested eight thousand dollars in JJ’s Lawn Care Service and received eight hundred shares of stock in return. Let’s see how the balance sheet would look immediately after this transaction.
Part II
You can see that the cash account of JJ’s Lawn Care increased by eight thousand dollars and the capital stock of the company also increased by eight thousand dollars. Notice that the basic accounting equation is in balance. Total assets are equal to total liabilities plus owners’ equity.
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47. On May 2, JJ’s purchased a riding lawn mower for $2,500 cash.
Part I
On the second of May, JJ’s Lawn Care purchased a riding lawn mower for twenty-five hundred dollars cash. Let’s see how the balance sheet looks now. Part II The cash account has been reduced by the twenty-five hundred dollars spent and the tools and equipment account has been increased by the same amount. We merely traded one asset, cash, for another, the riding lawn mower. Owner’s equity is not changed by the transaction and the basic accounting equation is still in balance.
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48. On May 8, JJ’s purchased a $15,000 truck.
JJ’s paid $2,000 down in cash and issued a note payable for the remaining $13,000.
Part I
In our next transaction JJ’s Lawn Care purchases a truck for fifteen thousand dollars, paying two thousand dollars cash and signing a note payable for thirteen thousand dollars. Now, let’s update the balance sheet. Part II The cash account decreased by two thousand dollars and the truck account increased by fifteen thousand dollars. There was a net increase in the asset side of the equation of thirteen thousand dollars. The liability account, notes payable, increased by thirteen thousand dollars. Total assets are now equal to twenty-one thousand dollars. Total liabilities are equal to thirteen thousand dollars and owners’ equity is equal to eight thousand dollars. The accounting equation is still in balance.
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49. On May 11, JJ’s purchased some repair parts for $300 on account.
Part I On May eleventh, JJ’s Lawn Care purchases repair parts for the riding lawn mower for three hundred dollars. The parts are purchased on account. JJ’s will pay the balance on the account at some point in the future. Let’s update the balance sheet. Part II
The tools and equipment account increased by three hundred dollars and the liability account, accounts payable, increased by the same amount. Our balance sheet is getting progressively more complicated.
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50. Jill realized she had purchased more repair parts than needed.
On May 18, JJ’s was able to sell half of the repair parts to ABC Lawns for $150, a price equal to JJ’s cost. JJ’s will receive the cash within 30 days.
Part I
On May eighteenth, JJ’s Lawn Care sells one-half of its repair parts at cost to ABC Lawns. ABC agrees to pay for the parts in thirty days. One-half of the cost of the parts is one hundred fifty dollars. Can you update the balance sheet? Try and do it before proceeding to the next slide.
Part II The asset accounts, tools and equipment, decreased by one hundred fifty dollars and the asset account, accounts receivable, increased by the same amount. Once again, we have exchanged one asset, repair parts, for another asset, accounts receivable. How did you do with your update?
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51. On May 25, ABC Lawns pays JJ’s $75 as a partial settlement of its accounts receivable.
On May twenty-fifth, ABC Lawns makes a partial payment on it account for seventy-five dollars cash. Let’s prepare the updated balance sheet on May twenty-fifth. Part II The cash account increases by seventy-five dollars and the accounts receivable decreases by the same amount. Notice that our total assets are still equal to total liabilities plus owners’ equity.
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52. On May 28, JJ’s pays $150 of its accounts payable.
Part I On May twenty-eighth, JJ’s Lawn Care makes a partial payment on its accounts payable of one hundred fifty dollars. Its time to update the balance sheet. Part II The cash account decreases by one hundred-fifty dollars and accounts payable also decreases by one hundred fifty dollars. The total assets are now recorded at twenty-one thousand one hundred fifty dollars. Total liabilities plus owners’ equity is equal to the same amount.
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53. On May 29, JJ’s recorded lawn care services provided during May of $750. All clients paid in cash.
Part I
On May twenty ninth, JJ’s Lawn Care begins providing services to customers. On this date the company did work that totaled seven hundred fifty dollars. All of the customers paid cash for the services rendered. Give updating the balance sheet a try now. Be careful with this one.
Part II The cash account increases by seven hundred fifty dollars and retained earnings increases by the same amount. The monies received represent earnings of the company that have been retained. The seven hundred fifty dollars represents revenue earned by the business. How did you do?
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54. On May 31, JJ’s purchased gasoline for the lawn mower and the truck for $50 cash.
Part I
In the final transaction for May, JJ’s Lawn Care purchased fifty dollars worth of gasoline for its riding mower and truck. Let’s make the final update to the balance sheet on May thirty first. Part II The cash account decreased by fifty dollars and so did the retained earnings of the company. JJ’s Lawn Care used fifty dollars of its earnings to pay for the gasoline. The fifty dollars spend is an expense of the business.
Now, let’s review how JJ’s transactions affected the accounting equation.
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55. On this slide we have placed all the transactions that impacted each account into the appropriate column so we can verify the balance in each account and get ready to prepare the financial statements for JJ’s Lawn Care.
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56. These transactions impact the Statement of Cash Flows.
Let’s prepare the Income Statement and Statement of Cash Flows for JJ’s Lawn Care Service for the month ending May 31, 2005.
These transactions impact the Statement of Cash Flows.
Part I All of the transactions that impact the cash account will appear on the statement of cash flows. Part II The revenues and expenses that caused the change in retained earnings will appear on the income statement of the company. Part II Let’s begin by preparing the income statement and statement of cash flows for JJ’s Lawn Care for the period ended May 31, 2005.
These transactions impact the Income Statement.
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57. Part I As you can see JJ’s Lawn care has one revenue for services for seven hundred fifty dollars, and one expense for gasoline of fifty dollars. So the net income for the month of May is seven hundred dollars. Remember, net income is the excess of revenues over expenses incurred during the accounting period. Part II Investments by owners and payments to owners do not appear on the income statement. These amounts appear on the company’s balance sheet.
Investments by and payments to the owners are not included on the Income Statement.
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58. Here is the statement of cash flows for JJ’s Lawn Care for the month ended May 31, You can clearly see the three sections of the statement.
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59. Operating activities include the cash effects of revenue and expense transactions.
Cash flows from operating activities include the seven hundred dollars in net income we calculated on the previous screen.
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60. JJ’s had a cash outflow for investing activities
JJ’s had a cash outflow for investing activities. The company invested in the riding lawn mower, truck and repair parts; however, the company recovered some of the cost of repair parts by selling them to ABC Lawns.
Investing activities include the cash effects of purchasing and selling assets.
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61. Financing activities include the cash effects of transactions with the owners and creditors.
The only financing activity was the original investment by the owners of JJ’s Lawn Care. The cash inflows and outflows resulted in an increase in cash of four thousand one hundred and twenty-five dollars during the month. Because the cash account had a zero balance at the beginning of the month, the ending balance in the cash account is four thousand one hundred twenty-five dollars. Let’s finish by preparing the balance sheet for JJ’s Lawn Care.
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62. These balances will appear on the Balance Sheet.
Now, let’s prepare the Balance Sheet for JJ’s Lawn Care Service for May 31, 2005.
These balances will appear on the Balance Sheet.
Here are the account balances we will use to prepare the balance sheet.
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63. Assets = Liabilities + Owners’ Equity $21,850 = $13,150 + $8,700
Part I
We list the asset accounts on the lefts of the balance sheet and the liabilities and owners’ equity accounts on the right. You can go back to the previous screen and see all the account balances that appear on the balance sheet. Part II As a final check we must make sure that the accounting equation is still in balance. The total assets of twenty-one thousand eight hundred fifty dollars is exactly equal to the total of the company’s liabilities plus its owners’ equity. Notice that the balance sheet lists all assets, liabilities and equities on a certain date. In our example, the date is May 31, 2005.
Assets = Liabilities + Owners’ Equity
$21,850 = $13, $8,700
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