1. Understanding Financial Statements Seventh EDITION Lyn M. Fraser Aileen Ormiston Insert BOOK COVER

2. (C) 2004 Prentice Hall, Inc.2-2 The Balance Sheet Chapter 2 “Old accountants never die; they just lose their balance” --Anonymous

3. (C) 2004 Prentice Hall, Inc.2-3 What is a Balance Sheet? Also called the statement of condition or statement of financial position Shows the financial condition or financial positions of a company on a particular date Financial Condition

4. (C) 2004 Prentice Hall, Inc.2-4 Financial Condition Continued Assets = What the firm owns Liabilities = What the firm owes to outsiders Stockholder’s equity = Internal owners Liabilities + Stockholders’ equity Liabilities + Stockholders’ equity Assets =

5. (C) 2004 Prentice Hall, Inc.2-5 Some General Parameters Financial statements are often CONSOLIDATED Balance sheet is DATED (end of accounting period): calendar year or fiscal year or interim period

6. (C) 2004 Prentice Hall, Inc.2-6 More General Parameters Some COMPARATIVE DATA is presented (e.g. balances for end of previous year shown on balance sheet) Balance sheet is prepared on a specific date

7. (C) 2004 Prentice Hall, Inc.2-7 Assets (the “left” side) Generally presented in order of liquidity Common Balance Sheet Accounts—Assets Current Assets Cash and Marketable Securities Account Receivables Inventories Prepaid Expenses Property, Plant, and Equipment Other Assets

8. (C) 2004 Prentice Hall, Inc.2-8 Some Definitions Current Assets--Cash or assets expected to be converted to cash within one year or operating cycle, whichever is longer Operating Cycle--Time required to purchase or manufacture inventory, sell the product, and collect the cash

9. (C) 2004 Prentice Hall, Inc.2-9 Another Definition Working Capital (Net working capital)— designates the amount by which current assets exceed current liabilities

10. (C) 2004 Prentice Hall, Inc.2-10 Cash and Marketable Securities  Cash in any form—cash awaiting deposit or in a back account  Generally includes currency, coin, balances in checking and other demand or “near demand” accounts Cash

11. (C) 2004 Prentice Hall, Inc.2-11 Cash and Marketable Securities continued  Are cash substitutes  Not needed immediately in the business  Temporarily invested to earn a return  May include T-bills, certificates, notes, bonds, CD’s and commercial paper Marketable Securities

12. (C) 2004 Prentice Hall, Inc.2-12 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...

13. (C) 2004 Prentice Hall, Inc.2-13 Statement of Financial Accounting Standards No. 115 Con’t. 1. Held to maturity 2. Trading securities 3. Securities available for sale

14. (C) 2004 Prentice Hall, Inc.2-14 Statement of Financial Accounting Standards No. 115 Con’t. Applies to those debt securities that the firm has the positive intent and ability to hold maturity Are reported at amortized cost Hold to Maturity

15. (C) 2004 Prentice Hall, Inc.2-15 Statement of Financial Accounting Standards No. 115 Con’t. Are debt and equity securities that are held for resale in the short term Are reported at fair value with unrealized gains and losses included in earnings Trading Securities

16. (C) 2004 Prentice Hall, Inc.2-16 Statement of Financial Accounting Standards No. 115 Con’t. Are debt and equity securities that are not classified as one of the other two categories Are reported at fair value with unrealized gains or losses included in comprehensive income Securities Available for Sale…

17. (C) 2004 Prentice Hall, Inc.2-17 Statement of Financial Accounting Standards No. 115 Con’t. Does not apply to investments in consolidated subsidiaries nor to investments in equity securities accounted for under the equity method

18. (C) 2004 Prentice Hall, Inc.2-18 Accounts Receivable Arise from credit-sale transactions Reported on the balance sheet at NET REALIZABLE VALUE -Allowance for Doubtful Accounts Net Realizable Value = Accounts Receivable

19. (C) 2004 Prentice Hall, Inc.2-19 A Word on the “Allowance…”  Management must estimate the dollar amount of accounts receivable estimated to be uncollectable  Affects balance sheet valuation AND bad debt expense on income statement  Can be important in assessing earnings quality--changes should be analyzed

20. (C) 2004 Prentice Hall, Inc.2-20 Inventories Are items held for sale or used in the manufacture of products that will be sold

21. (C) 2004 Prentice Hall, Inc.2-21 Inventories Continued Retail Company One type of inventory: Finished goods Manufacturing Company Three types of inventories:  Raw materials  Work-in-process  Finished goods

22. (C) 2004 Prentice Hall, Inc.2-22 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

23. (C) 2004 Prentice Hall, Inc.2-23 Inventory Accounting Methods Continued Three cost flow assumptions: FIFO (First In, First Out) LIFO (Last In, First Out) Average cost

24. (C) 2004 Prentice Hall, Inc.2-24 Inventory Accounting Methods Continued 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

25. (C) 2004 Prentice Hall, Inc.2-25 During Inflation Produces the highest COGS expense and the lowest ending inventory valuation Matches current costs to current sales LIFO

26. (C) 2004 Prentice Hall, Inc.2-26 During Inflation Produces the lowers COGS expense and the highest inventory valuation Values ending inventory at current cost FIFO

27. (C) 2004 Prentice Hall, Inc.2-27 Inventory Accounting Methods Continued 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

28. (C) 2004 Prentice Hall, Inc.2-28 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

29. (C) 2004 Prentice Hall, Inc.2-29 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

30. (C) 2004 Prentice Hall, Inc.2-30 Property, Plant, and Equipment (PP&E) Continued On any balance sheet date, PP&E is shown at book value Book value = difference between original cost and any accumulated depreciation to date

31. (C) 2004 Prentice Hall, Inc.2-31 Property, Plant, and Equipment (PP&E) Continued  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:   

32. (C) 2004 Prentice Hall, Inc.2-32 Property, Plant, and Equipment (PP&E) Continued Comparison among firms can be made difficult with different methods and different estimates Proportion of fixed assets (PP&E) in a company’s asset structure determined by nature of the business Depreciation methods:

33. (C) 2004 Prentice Hall, Inc.2-33 Other Assets Can include multitude of other noncurrent items, for example: Property held for sale Start-up costs in connections with a new business with a new business Cash surrender value of life insurance policies Long-term advance payments Long-term investments Intangible assets

34. (C) 2004 Prentice Hall, Inc.2-34 Other Assets—Intangible Most important for analytical purposes Arises when one company acquired another company for a price in excess of the fair market value of the net identifiable assets acquired Goodwill

35. (C) 2004 Prentice Hall, Inc.2-35 Goodwill Continued Beginning in 2002, companies will evaluate goodwill and determine whether it has lost value

36. (C) 2004 Prentice Hall, Inc.2-36 Goodwill Continued What that means is that some corporations will take enormous write-offs when companies they have acquired have lost value

37. (C) 2004 Prentice Hall, Inc.2-37 Goodwill Continued Earnings may increase for some firms relative to prior years because amortization expense will no longer be recorded

38. (C) 2004 Prentice Hall, Inc.2-38 Goodwill Continued Companies will also have some discretion in deciding when and how much write-off to take as a result of goodwill impairment

39. (C) 2004 Prentice Hall, Inc.2-39 Goodwill Continued On the plus side.... Firms will not have to deduct amortization expense each year, which will increase earnings for many companies

40. (C) 2004 Prentice Hall, Inc.2-40 Liabilities Represent claims against assets Current Liabilities include: Accounts Payable Notes Payable Current Portion of Long-Term Debt Accrued Liabilities Unearned Revenue Deferred Taxes

41. (C) 2004 Prentice Hall, Inc.2-41 Liabilities Continued  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 Accounts Payable

42. (C) 2004 Prentice Hall, Inc.2-42 Liabilities Continued  Short-term obligations in the form of promissory notes to suppliers or financial institutions  Reflect the amount extended under a line of credit Notes Payable

43. (C) 2004 Prentice Hall, Inc.2-43 Liabilities Continued 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

44. (C) 2004 Prentice Hall, Inc.2-44 Liabilities Continued  Result from accrual basis of accounting  Represent expenses that have been INCURRED and thus ACCRUED, but have NOT BEEN PAID in cash  In this case, cash flow follows expense recognition Accrued Liabilities

45. (C) 2004 Prentice Hall, Inc.2-45 Liabilities Continued  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 Unearned Revenue or Deferred Credits

46. (C) 2004 Prentice Hall, Inc.2-46 Liabilities Continued Are the result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income Deferred Federal Income Taxes

47. (C) 2004 Prentice Hall, Inc.2-47 Deferred Federal Income Taxes Continued The 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

48. (C) 2004 Prentice Hall, Inc.2-48 Deferred Federal Income Taxes Continued Are when the total amount of expense and revenue recognized will eventually be the same for tax and reporting purposes Temporary Differences

49. (C) 2004 Prentice Hall, Inc.2-49 Deferred Federal Income Taxes Continued 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

50. (C) 2004 Prentice Hall, Inc.2-50 Long-Term Debt Capital Lease Obligations Postretirement Benefits Other Than Pensions Commitments and Contingencies Hybrid Securities Obligations with maturities beyond one year

51. (C) 2004 Prentice Hall, Inc.2-51 Long-Term Debt Continued  Are, in substance, a “purchase” rather than a “lease”  Affect both balance sheet and income statement Capital Lease Obligations

52. (C) 2004 Prentice Hall, Inc.2-52 Long-Term Debt Continued  Can appear under the liability section of the balance sheet  Can have a significant impact on many corporate balance sheets Postretirement Benefits Other Than Pensions

53. (C) 2004 Prentice Hall, Inc.2-53 Long-Term Debt Continued Intended to draw attention to the fact that required disclosures can be found in the notes to the financial statements Commitments and Contingencies

54. (C) 2004 Prentice Hall, Inc.2-54 Long-Term Debt Continued Refer to contractual agreements that will have a significant financial impact on the company in the future Commitments

55. (C) 2004 Prentice Hall, Inc.2-55 Long-Term Debt Continued Refer to potential liabilities of the firm such as possible damage awards assessed in lawsuits Contingencies

56. (C) 2004 Prentice Hall, Inc.2-56 Long-Term Debt Continued 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 For example:

57. (C) 2004 Prentice Hall, Inc.2-57 Stockholders’ Equity Ownership equity is the residual interest in assets that remains after deducting liabilities

58. (C) 2004 Prentice Hall, Inc.2-58 Stockholders’ Equity Continued 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

59. (C) 2004 Prentice Hall, Inc.2-59 Stockholders’ Equity Continued Reflects the amount by which the original sales price of the stock shares exceeded par value Additional Paid-In Capital

60. (C) 2004 Prentice Hall, Inc.2-60 Stockholders’ Equity Continued 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 Retained Earnings

61. (C) 2004 Prentice Hall, Inc.2-61 Stockholders’ Equity Continued Other accounts that can appear in the equity section are: Preferred stock Accumulated other comprehensive income Treasury stock Other Equity Accounts

62. (C) 2004 Prentice Hall, Inc.2-62 Stockholders’ Equity Continued 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 Other Balance Sheet Items

63. (C) 2004 Prentice Hall, Inc.2-63 The Journey Through the Maze Continues Ch. 3:The Income Statement and Statement of Stockholders’ Equity Ch. 4:Statement of Cash Flows Ch. 5:The Analysis of Financial Statements