1. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing UNDERSTANDING FINANCIAL STATEMENTS THE BALANCE SHEET Chapter 2

2. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing What is a BALANCE SHEET? A “statement of financial condition” On a particular date (a “snapshot”) OBJECTIVES: –a fundamental understanding of accounts described on a balance sheet –a feel for the relationship of each account to the financial statements as a whole

3. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing The Basic Equation ASSETS = LIABLITIES + STOCKHOLDERS’ EQUITY –Where assets are economic resources (the left side of the equation) –Where liabilities and equities are claims to those resources (the right side of the equation)

4. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Another look: Basic Equation ASSETS are what the firm owns LIABILITIES are what the firm owes to outsiders EQUITIES are what the firm owes to insiders Therefore: Assets = Liabilities + Stockholders’ Equity represents equality between resources and claims to resources

5. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing “Time for a Walk….” An “account by account” stroll through the balance sheet using R.E.C., Inc. as an example of a U.S. company reporting under US GAAP and SEC requirements Focus is on some typical balance sheet accounts -- what they are, where the numbers come from, what they MEAN!

6. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Some General Parameters Financial statements are often CONSOLIDATED Balance sheet is DATED (end of accounting period): calendar year or fiscal year or interim period Some COMPARATIVE DATA is presented (e.g. balances for end of previous year shown on balance sheet)

7. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing ASSETS (the “left” side) Generally presented in order of liquidity Current Assets -- defined as cash or assets expected to be converted to cash within one year or operating cycle, whichever is longer –operating cycle is time required to purchase/manufacture the inventory, sell it and collect the cash

8. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing ASSETS (continued) Noncurrent Assets -- defined as assets expected to be converted to cash after the completion of one year or one operating cycle, whichever is longer

9. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing A Look at Current Assets Cash Marketable Securities (short-term) Accounts Receivable Notes Receivable (short-term) Inventory Prepaid Expenses

10. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing...and Noncurrent Assets? Long-term Investments Property, Plant and Equipment Intangible Assets “Other” Assets -- the “catchall” category

11. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Okay, let’s go one-by-one: First we’ll look at typical current assets Then we’ll turn our attention to typical noncurrent assets –Later we’ll look at liabilities and equities (the “right” side of the equation) Objective is to understand what the category is and what the numbers mean (sometimes this is easy, then sometimes….)

12. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Cash The most liquid of assets Generally includes currency, coin, balances in checking and other demand or “near demand” accounts

13. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Marketable Securities Refers to short-term investments that the firm INTENDS to hold for less than one year (thus a “current” asset) Generally reported on balance sheet at market value May include t-bills, CDs, stocks, bonds Sometimes combined with cash and reported as Cash Equivalents

14. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Accounts Receivable Arise from credit-sale transactions Reported on the balance sheet at NET REALIZABLE VALUE –Accounts Receivable $$$ –Less Allowance for Doubtful Accounts $$$ –Net Accounts Receivable $$$

15. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing A Word on the “Allowance…” Management must estimate the dollar amount of accounts 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

16. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Inventory Consist of items held for sale or used in manufacture of goods for sale Merchandising Company –one type of inventory (finished goods) Manufacturing Company –three types of inventories (raw materials, work-in-process, finished goods) Often a BIG dollar item -- often firm’s major revenue producer

17. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Inventory Issues Major concern with method of valuation (which MUST be DISCLOSED) –FIFO (first-in, first-out) –LIFO (last-in, first-out) –Average Cost

18. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing More Inventory Issues Inventory valuations SIGNIFICANTLY affects BOTH the balance sheet and the income statement Disclosure of inventory cost flow assumption found on face of balance sheet or (more commonly) in notes Inventory reported on balance sheet at LOWER OF COST OR MARKET

19. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Prepaid Expenses Represent expenses paid in advance -- included in current assets if they expire within one year or operating cycle Usually not a material item Present few or no reporting or valuation issues ON TO NONCURRENT ASSETS…….

20. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Property, Plant & Equipment (PP&E) Often called “fixed assets” Represent major resource commitments which benefit a firm for more than one year Recorded at HISTORICAL cost; cost allocated over asset’s useful life through DEPRECIATION (exception: land is not depreciated)

21. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing PP&E Issues PP&E is reported on balance sheet at historical cost less accumulated depreciation to date Depreciation process involves ESTIMATES Depreciated cost reported on balance sheet is reliable; one might seriously question how relevant it is...

22. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing More PP&E Issues Firm has CHOICE of depreciation method: accelerated, straight-line Comparison among firms can be made difficult with different methods and different estimates Proportion of fixed assets (PP&E) in a firm’s asset structure determined by nature of the business

23. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Intangible Assets Resources with expected future economic benefits but lacking a physical substance Some examples are patents, copyrights, goodwill Goodwill can be material if firm is heavily involved in acquisition activity

24. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Other Assets Can include multitude of other noncurrent items, for example –property held for sale –long-term investments –start-up costs in connection with a new business –cash surrender value of life insurance policies –long term advance payments

25. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing NOW WHAT???? NOW, HOW ABOUT THE OTHER (“RIGHT”) SIDE OF THE BALANCE SHEET……. Let’s take a look at liabilities and equities (the “claims” to the assets we just looked at…)

26. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing LIABILITIES & EQUITIES REPRESENT CLAIMS TO ASSETS LIABILITIES: Creditor Claims EQUITIES: Owner Claims Constitute the “right” side of equation

27. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing LIABILITIES May be CURRENT or LONG-TERM -- same criteria of “one-year or operating cycle, whichever is longer” applies here as well Represent claims by creditors of the firm

28. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing A Look at Current Liabilities Accounts Payable Short-term Notes Payable Accrued Liabilities Unearned Revenues (Deferred Credits) Current Maturity Portion of Long-term Debt Deferred Taxes (some, not all or even most…)

29. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing …and Long-Term Liabilities? Notes or Mortgages Payables Bonds Payable Pension and Lease Obligations Deferred Taxes (most) Warranty Obligations Other Long-Term Debt Okay, let’s look at some of these…..starting with Current Liabilities

30. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Accounts Payable Usually defined as obligations arising from purchases of merchandise for resale or of raw materials Few valuation or reporting issues Significant changes from period to period often result from changes in sales volume

31. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Short-Term Notes Payable Promissory notes due within a year (or operating cycle if more appropriate) Usually are interest-bearing Usually reported at face value because of short-term nature

32. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Accrued Liabilities Result from accrual basis of accounting Represent expenses that have been INCURRED and thus ACCRUED, but have NOT BEEN PAID in cash Examples are Interest Payable and Wages Payable In this case, cash flow follows expense recognition

33. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Unearned Revenue Sometimes called “deferred credits” Results from a prepayment received in advance for services or products Under accrual accounting, revenue is recognized when EARNED, not when received in cash -- in this case, cash flow precedes revenue recognition

34. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Current Maturities - LT Debt Represent principal payments on debt that are due within one year Confirms the old adage that nothing is long-term forever -- eventually it has to be paid as a current item! Now, how about those items that are STILL LONG-TERM LIABILITIES

35. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Notes or Mortgages Payable Represent any mortgages or notes payable that do not have any principal repayment requirements during the coming year

36. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Bonds Payable Once again, represent items that do not have any principal payment requirements within the next year

37. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Pension & Lease Obligations Generally reported at the present value of expected future cash outflows Can represent MAJOR liabilities for many firms and have a significant impact on the balance sheet

38. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Warranty Obligations Represent liability of a firm to repair or replace merchandise that it sells Some estimating is necessary, but if the firm regularly sells items with a warranty attached, the liability must be disclosed...

39. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Deferred Income Taxes NO, we didn’t forget this one... Financial Statement Income DOES NOT NECESSARILY EQUAL Taxable Income!!! Taxes paid are based on TAXABLE income as defined by the IRS; tax expense reported on income statement is based on FINANCIAL statement income

40. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Deferred Income Taxes (cont.) Deferred Income Taxes result from TIMING (temporary) differences in taxable and financial statement income Examples are many: –depreciation (major difference for many) –pension expense –installment sale accounting –others

41. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing More on Deferred Taxes Classification may be current or long- term depending on the asset or liability underlying the temporary difference Most are found in the long-term liability section

42. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Other Long-Term Debt Once again, a “catch-all” category for long term obligations not reported elsewhere -------------------------- NOW, WHAT ABOUT OWNER CLAIMS???

43. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Stockholders’ Equity Represent claims to assets by OWNERS, i.e. stockholders Is often referred to as a RESIDUAL; this flows from a restatement of the basic equation: ASSETS - LIABILITIES = EQUITIES

44. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing More on Stockholders’ Equity Usually consists of STOCK ACCOUNTS AND ADDITIONAL PAID- IN CAPITAL and RETAINED EARNINGS -- may have other equity accounts May have more than one “class” of stock: common stock and one or more issues of preferred stock

45. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing More on Stockholders’ Equity Shares of common stock represent ownership of the firm Stock usually has a PAR VALUE

46. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing STOCK AND ADDITIONAL PAID-IN CAPITAL Common and Preferred Stock accounts often carry balances representing “par value” of outstanding shares Additional paid-in Capital accounts reflect balances over and above par value (from original sales of stock)

47. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Retained Earnings In simplest terms, represents the cumulative undistributed earnings of the business since its inception Represent funds the company has chosen to “retain” and reinvest in the business RETAINED EARNINGS DOES NOT REPRESENT A PILE OF CASH!!!!!!!

48. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing “Other” Equity Accounts? Can include such things as unrealized holding gains/losses on investments, treasury stock, foreign currency translation effects

49. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing So, What Have We Learned? Balance Sheet is a “snapshot” Assets = Liabilities & Equities Can “walk” through a balance sheet and (a) understand what the account titles mean and (b) have at least the beginnings of an understanding of where some of the numbers come from

50. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing So What’s Next? Everything you want or need to know cannot be found on the balance sheet Next we will look at the income statement and try to understand what it’s trying to tell us Also, we need to become aware there are many important relationships between income statement and balance sheet items……..

51. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing For Example……. A firm’s sales are growing -- normally this would be a good trend BUT, accounts receivable are growing FASTER than sales are growing….this may be a sign of trouble brewing down the road Information on more than one financial statement can help us find these relationships….

52. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing “Coming Attractions” NEXT ON THE AGENDA: THE INCOME STATEMENT