1. Understanding Financial Statements EIGHTH EDITION Lyn M. Fraser Aileen Ormiston

2. (C) 2007 Prentice Hall, Inc.2-2 The Balance Sheet “Old accountants never die; they just lose their balance” --Anonymous

3. (C) 2007 Prentice Hall, Inc.2-3 The Balance Sheet Also called the statement of condition or statement of financial position Shows the financial condition or financial position of a company on a particular date Financial Condition

4. (C) 2007 Prentice Hall, Inc.2-4 Financial Condition (cont.) Assets = What the firm owns Liabilities = What the firm owes to outsiders Stockholders’ equity = What the firm owes to Internal owners Liabilities + Stockholders’ equity Liabilities + Stockholders’ equity Assets =

5. (C) 2007 Prentice Hall, Inc.2-5 General Parameters  Consolidation – when financial statements are combined due to parent owning more than 50% of voting stock in subsidiary  Balance Sheet Date  prepared at a point in time/on a particular date at end of accounting period  end of accounting period date can be calendar year or fiscal year or interim period such as year, quarter, etc.

6. (C) 2007 Prentice Hall, Inc.2-6 General Parameters (cont.)  Comparative Data  SEC requires that Balance Sheet includes two years of data (current and prior year balances)  Provides reference point for determining changes in financial position over time

7. (C) 2007 Prentice Hall, Inc.2-7 General Parameters (cont.)  Common-Size balance sheet  useful tool for analyzing the balance sheet  expresses each item on the balance sheet as a percentage of total assets  form of vertical ratio analysis that allows comparison of firms regardless of size  useful for evaluating trends within a firm and to make industry comparisons

8. (C) 2007 Prentice Hall, Inc.2-8 Common-Size balance sheet (cont.) Comparison of two major retail companies* Comparison using $ ($ are in millions): Retailer A Retailer B Retailer A Retailer B Cash $ 5,488 $ 2,245 A/R 1,715 5,069 Inventories 29,447 5,384 Current Assets 38,491 13,922 PPE, net 65,408 16,860 Total Assets 120,223 32,293 *Data from SEC website, www.sec.gov www.sec.gov

9. (C) 2007 Prentice Hall, Inc.2-9 Common-Size balance sheet (cont.) Comparison of two major retail companies* Comparison using common size balance sheet %: Retailer A Retailer B Retailer A Retailer B Cash 4.566.95 A/R 1.43 15.70 Inventories 24.49 16.67 Current Assets 32.02 43.11 PPE, net 54.41 52.21 *Data from SEC website, www.sec.gov www.sec.gov

10. (C) 2007 Prentice Hall, Inc.2-10 Assets Generally presented in order of liquidity Common Balance Sheet Accounts/Groupings  Current Assets  Cash and Marketable Securities  Accounts Receivable  Inventories  Prepaid Expenses  Long-Term Assets  Property, Plant, and Equipment  Other Assets

11. (C) 2007 Prentice Hall, Inc.2-11 A Few Definitions Current Assets-Cash or other assets expected to be converted into cash within one year or one operating cycle, whichever is longer Operating Cycle-Time required to purchase or manufacture inventory, sell the product, and collect the cash

12. (C) 2007 Prentice Hall, Inc.2-12 A Few Definitions (cont.) Working Capital (Net working capital)— designates the amount by which current assets exceed current liabilities

13. (C) 2007 Prentice Hall, Inc.2-13 Cash and Marketable Securities Two accounts are often combined as “Cash and Cash Equivalents”  Cash in any form—cash awaiting deposit or in a bank account  Generally includes currency, coin, balances in checking and other demand or “near demand” accounts Cash

14. (C) 2007 Prentice Hall, Inc.2-14 Cash and Marketable Securities (cont.)  Also called “short-term investments”  Are cash substitutes  Represent cash not needed immediately in the business  Temporarily invested to earn a return  Have short-term maturities  May include T-bills, certificates, notes, bonds, CD’s and commercial paper Marketable Securities

15. (C) 2007 Prentice Hall, Inc.2-15 Statement of Financial Accounting Standards No. 115 Effective for fiscal years beginning after December 15, 1993 Requires the separation of investment securities into three categories: 1. Held to maturity 2. Trading securities 3. Securities available for sale

16. (C) 2007 Prentice Hall, Inc.2-16 Statement of Financial Accounting Standards No. 115 (cont.) Applies to debt securities that the firm has the positive intent and ability to hold to maturity Reported at amortized cost Held to Maturity

17. (C) 2007 Prentice Hall, Inc.2-17 Statement of Financial Accounting Standards No. 115 (cont.) Debt and equity securities that are held for resale in the short term Reported at fair value with unrealized gains and losses included in earnings Trading Securities

18. (C) 2007 Prentice Hall, Inc.2-18 Statement of Financial Accounting Standards No. 115 (cont.) Debt and equity securities that are not classified as one of the other two categories Reported at fair value with unrealized gains or losses included in comprehensive income Securities Available for Sale

19. (C) 2007 Prentice Hall, Inc.2-19 Statement of Financial Accounting Standards No. 115 (cont.) Does not apply to investments in consolidated subsidiaries nor to investments in equity securities accounted for under the equity method

20. (C) 2007 Prentice Hall, Inc.2-20 Accounts Receivable Arise from sales transactions to customers on credit Reported on the balance sheet at NET REALIZABLE VALUE - Allowance for Doubtful Accounts Net Realizable Value = Accounts Receivable

21. (C) 2007 Prentice Hall, Inc.2-21 A Word on the “Allowance…”  Management must estimate the dollar amount of accounts receivable they expect to be uncollectible  Affects balance sheet valuation AND bad debt expense on income statement  Can be important in assessing earnings quality--changes should be analyzed

22. (C) 2007 Prentice Hall, Inc.2-22 Inventories Items held for sale or used in the manufacture of products that will be sold

23. (C) 2007 Prentice Hall, Inc.2-23 Inventories (cont.) Retail Company One type of inventory: Finished goods Manufacturing Company Three types of inventories:  Raw materials  Work-in-process  Finished goods

24. (C) 2007 Prentice Hall, Inc.2-24 Inventories (cont.) Accounting method chosen to value inventory and the associated measurement of cost of goods sold have a considerable impact on a company’s financial position and operating results

25. (C) 2007 Prentice Hall, Inc.2-25 Inventory Accounting Methods Inventory valuation is based on an assumption regarding the flow of goods Has nothing to do with the actual order in which products are sold Cost flow assumption made in order to match the cost of products sold to the revenue generated

26. (C) 2007 Prentice Hall, Inc.2-26 Inventory Accounting Methods (cont.) Three cost flow assumptions: FIFO (First In, First Out) LIFO (Last In, First Out) Average cost

27. (C) 2007 Prentice Hall, Inc.2-27 Inventory Accounting Methods (cont.) Accounting Method FIFO LIFO Average Cost Cost of Goods Sold (Income Statement) first purchases last purchases (close to current cost) average of all purchases Inventory Valuation (Balance Sheet) last purchases (close to current cost) first purchases average of all purchases

28. (C) 2007 Prentice Hall, Inc.2-28 Inventory Accounting Methods (cont.) Inventory Accounting Methods (cont.) Produces the highest COGS expense and the lowest ending inventory valuation Matches current costs to current sales LIFO During Inflation

29. (C) 2007 Prentice Hall, Inc.2-29 Inventory Accounting Methods (cont.) Produces the lowest COGS expense and the highest ending inventory valuation Values ending inventory at current cost FIFO During Inflation

30. (C) 2007 Prentice Hall, Inc.2-30 Inventory Accounting Methods (cont.) Inventory valuation may significantly affect BOTH the balance sheet and the income statement Disclosure of inventory cost flow assumption found in notes Inventory reported on balance sheet at LOWER OF COST OR MARKET

31. (C) 2007 Prentice Hall, Inc.2-31 Prepaid Expenses Represent expenses paid in advance-- included in current assets if they expire within one year or one operating cycle Usually not a material item Present few or no reporting or valuation issues

32. (C) 2007 Prentice Hall, Inc.2-32 Property, Plant, and Equipment (PP&E) Encompasses a company’s fixed assets  Also called tangible, long-lived, and capital assets Fixed assets other than land are “depreciated” over the period of time they benefit the firm  process of depreciation is method of allocating the cost of long-lived assets

33. (C) 2007 Prentice Hall, Inc.2-33 Property, Plant, and Equipment (PP&E) (cont.) On any balance sheet date, PP&E is shown at BOOK VALUE Book value = original cost - accumulated depreciation to date - accumulated depreciation to date

34. (C) 2007 Prentice Hall, Inc.2-34 Property, Plant, and Equipment (PP&E) (cont.)  Straight line spreads the expense evenly by periods  Accelerated yields higher depreciation expense in the early years of an asset’s useful life, and lower depreciation expense in the later years  Units of production bases depreciation expense for a given period on actual use Depreciation methods:   

35. (C) 2007 Prentice Hall, Inc.2-35 Property, Plant, and Equipment (PP&E) (cont.) Proportion of fixed assets (PP&E) in a company’s asset structure determined by nature of the business Comparisons between firms can be difficult due to different depreciation methods and estimates

36. (C) 2007 Prentice Hall, Inc.2-36 Other Assets Can include multitude of other noncurrent items such as:  Property held for sale  Start-up costs in connection with a new business  Cash surrender value of life insurance policies  Long-term advance payments  Long-term investments  Intangible assets

37. (C) 2007 Prentice Hall, Inc.2-37 Other Assets—Intangible Most important for analytical purposes because of potential materiality Arises when one company acquires another company for a price in excess of the fair market value of the net identifiable assets acquired Goodwill

38. (C) 2007 Prentice Hall, Inc.2-38 Goodwill (cont.) Beginning in 2002, companies required to evaluate goodwill and determine whether it has lost value Amount of impairment is expensed in the year the determination is made

39. (C) 2007 Prentice Hall, Inc.2-39 Goodwill (cont.) Some corporations take enormous write-offs when companies they have acquired lose value Earnings increase for some firms relative to prior years because amortization expense is no longer recorded

40. (C) 2007 Prentice Hall, Inc.2-40 Goodwill (cont.) Companies have some discretion in deciding when and how much write-off to take as a result of goodwill impairment

41. (C) 2007 Prentice Hall, Inc.2-41 Goodwill (cont.) ($ in millions) ($ in millions) YearGW ImpairmentGW Amortization 2005 $ 24 $ ---- 2004 10 ---- 2003 318 ---- 200244,039 ---- 2001 ---- 6,366 *Data from SEC website, www.sec.gov *Data from SEC website, www.sec.govwww.sec.gov Example of the impact the 2002 change for goodwill expense had on a major entertainment company over a 5 year period *

42. (C) 2007 Prentice Hall, Inc.2-42 Liabilities Represent claims against assets by creditors Current Liabilities must be satisfied in one year or one operating cycle and include:  Accounts Payable  Notes Payable  Current Portion of Long-Term Debt  Accrued Liabilities  Unearned Revenue  Deferred Taxes

43. (C) 2007 Prentice Hall, Inc.2-43 Liabilities (cont.)  Short-term obligations that arise from credit extended by suppliers for the purchase of goods and services  Account is eliminated when the bill is satisfied  Significant changes from period to period often result from changes in sales volume, economic conditions or credit policies available to firm from its suppliers Accounts Payable

44. (C) 2007 Prentice Hall, Inc.2-44 Liabilities (cont.)  Short-term obligations in the form of promissory notes and/or lines of credit to suppliers or financial institutions Notes Payable

45. (C) 2007 Prentice Hall, Inc.2-45 Liabilities (cont.) When a firm has bonds, mortgages, or other forms of long-term debt outstanding, the portion of the principal that will be repaid during the upcoming year is classified as a current liability Current Maturities of Long-Term Debt

46. (C) 2007 Prentice Hall, Inc.2-46 Liabilities (cont.)  Result from recognition of expenses before they are actually paid  Under accrual accounting, expenses are recognized when INCURRED and thus ACCRUED, not when paid in cash  In this case, cash flow succeeds expense recognition Accrued Liabilities

47. (C) 2007 Prentice Hall, Inc.2-47 Liabilities (cont.)  Result from prepayments received in advance for services or products  Under accrual accounting, revenue is recognized when EARNED, not when cash is received  In this case, cash flow precedes revenue recognition Unearned Revenue or Deferred Credits

48. (C) 2007 Prentice Hall, Inc.2-48 Liabilities (cont.) Result of temporary differences in the recognition of revenue and expense for taxable income relative to reported financial income Deferred Federal Income Taxes

49. (C) 2007 Prentice Hall, Inc.2-49 Deferred Federal Income Taxes (cont.) Objective is to take advantage of all available tax deferrals in order to reduce actual tax payments, while showing the highest possible amount of reported net income

50. (C) 2007 Prentice Hall, Inc.2-50 Deferred Federal Income Taxes (cont.) When the total amount of expense and revenue recognized will eventually be the same for tax and financial reporting purposes Temporary Differences/Timing Differences

51. (C) 2007 Prentice Hall, Inc.2-51 Deferred Federal Income Taxes (cont.) Do not affect deferred taxes because a tax will never be paid on the income or the expense will never be deducted on the tax return Permanent Differences

52. (C) 2007 Prentice Hall, Inc.2-52 Noncurrent Liabilities Noncurrent Liabilities  Long-Term Debt  Capital Lease Obligations  Postretirement Benefits Other Than Pensions  Commitments and Contingencies  Hybrid Securities Obligations with maturities beyond one year Obligations with maturities beyond one year

53. (C) 2007 Prentice Hall, Inc.2-53 Noncurrent Liabilities (cont.) Noncurrent Liabilities (cont.)  Bonds  Long-Term Notes Payable  Mortgages  Obligations under leases  Pension Liabilities  Long-Term Warranties Long-Term Debt Long-Term Debt

54. (C) 2007 Prentice Hall, Inc.2-54 Noncurrent Liabilities (cont.)  Are, in substance, a “purchase” rather than a “lease”  Affect both balance sheet and income statement Capital Lease Obligations

55. (C) 2007 Prentice Hall, Inc.2-55 Noncurrent Liabilities (cont.)  Can appear under the liability section of the balance sheet  Can have a significant impact on corporate balance sheets  Can also impact profitability by substantially increasing the recognition of annual postretirement benefit expense Postretirement benefits Other Than Pensions

56. (C) 2007 Prentice Hall, Inc.2-56 Noncurrent Liabilities (cont.) Intended to draw attention to the fact that required disclosures can be found in the notes to the financial statements Commitments and Contingencies

57. (C) 2007 Prentice Hall, Inc.2-57 Noncurrent Liabilities (cont.) Refer to contractual agreements that will have a significant financial impact on the company in the future For example: An operating lease is a common type of commitment and is a form of off-balance-sheet financing Commitments

58. (C) 2007 Prentice Hall, Inc.2-58 Noncurrent Liabilities (cont.) Refer to potential liabilities of the firm such as possible damage awards assessed in lawsuits Contingencies

59. (C) 2007 Prentice Hall, Inc.2-59 Noncurrent Liabilities (cont.) Have the characteristics of both debt and equity Some companies have mandatorily redeemable preferred stock outstanding Some companies have mandatorily redeemable preferred stock outstanding Hybrid Securities Hybrid Securities For example:

60. (C) 2007 Prentice Hall, Inc.2-60 Stockholders’ Equity Ownership equity is the residual interest in assets that remains after deducting liabilities

61. (C) 2007 Prentice Hall, Inc.2-61 Stockholders’ Equity (cont.) Shareholders: Do not ordinarily receive a fixed return Have voting privileges in proportion to ownership interest Dividends are declared at the discretion of a company’s board of directors Common Stock

62. (C) 2007 Prentice Hall, Inc.2-62 Stockholders’ Equity (cont.) Reflects the amount by which the original sales price of the stock shares exceeded par value Additional Paid-In Capital

63. (C) 2007 Prentice Hall, Inc.2-63 Stockholders’ Equity (cont.) Is the sum of every dollar a company has earned since its inception, less any payments made to shareholders in the form of cash or stock dividends Beginning retained earnings ± Net income (loss) – Dividends = Ending retained earnings = Ending retained earnings Retained Earnings

64. (C) 2007 Prentice Hall, Inc.2-64 Stockholders’ Equity (cont.) Other accounts that can appear in the equity section include: Preferred stock Accumulated other comprehensive income Treasury stock Other Equity Accounts

65. (C) 2007 Prentice Hall, Inc.2-65 Other Balance Sheet Items Corporate balance sheets are not limited to the accounts described in this chapter The reader of annual reports will encounter additional accounts and will also find many of the same accounts listed under a variety of different titles

66. (C) 2007 Prentice Hall, Inc.2-66 The Journey Through the Maze Continues Ch. 3:Income Statement and Statement of Stockholders’ Equity Ch. 4:Statement of Cash Flows Ch. 5:A Guide to Earnings and Financial Reporting Quality Ch. 6:The Analysis of Financial Statements