1. Copyright © 2015 McGraw-Hill Education. All rights reserved. Chapter 3 The Balance Sheet and Financial Disclosures

2. Balance Sheet LO3- 1 (Statement of Financial Position) Reports a company’s financial position at a point in time Organized array of assets, liabilities, and shareholders’ equity–grouped in common characteristics

3. Balance Sheet: Usefulness and Limitations Usefulness: Liquidity—a company’s ability to pay its current obligations Long-term solvency—indicates: Riskiness of a company with regard to the amount of liabilities in its capital structure Financial flexibility Limitations: Does not portray the market value of the entity Heavily reliant on estimates rather than determinable amounts LO3- 1

4. Classification of Elements LO3- 2

5. Classification of Elements: Assets CURRENT ASSETS Assets expected to be converted to cash within the coming year or within the normal operating cycle of the business if that’s longer than one year LO3- 2 Use cash to acquire raw materials Convert raw materials to finished product Deliver product to customer Collect cash from customer 1 2 3 4 Operating Cycle of a Typical Manufacturing Company

6. Classification of Elements: Assets CURRENT ASSETS Assets expected to be converted to cash within the coming year or within the normal operating cycle of the business if that’s longer than one year  Cash and cash equivalents  Short-term investments  Accounts receivable  Inventories  Prepaid expenses LO3- 2

7. Current Assets—PetSmart, Inc. LO3- 2

8. Classification of Elements: Assets CURRENT ASSETS Cash Equivalents: Maturity date of three months or less from the date of purchase LO3- 2 On handIn Banks Cash Bank drafts Cashier’s checks Money orders Also: Commercial paper Money market funds U.S. treasury bills

9. LO3- 2 Classification of Elements: Assets CURRENT ASSETS Short-Term Investments Investments in stock and debt securities of other corporations That the company has the ability and intent to sell within the next 12 months or operating cycle, whichever is longer Short-Term Investments Held to maturity Trading securities Securities available for sale

10. LO3- 2 Classification of Elements: Assets CURRENT ASSETS Accounts Receivable Result from the sale of goods or services on credit Often referred to as trade receivables Nontrade receivables result from loans by the company Notes receivable Supported by a formal agreement or note that specifies payment terms

11. LO3- 2 Classification of Elements: Assets CURRENT ASSETS Inventories Finished goods Work in process Raw materials Inventories Disclosure—Intel Corp.

12. LO3- 2 Classification of Elements: Assets CURRENT ASSETS Prepaid Expenses Represent assets recorded when expenses are paid in advance creating benefits beyond the current period Current or noncurrent depends on when its benefits will be realized Examples Prepaid rent and prepaid insurance

13. LO3- 2 Current assets include cash and all other assets expected to become cash or be consumed: a.Within one year. b.Within one operating cycle. c.Within one year or one operating cycle, whichever is shorter. d.Within one year or one operating cycle, whichever is longer. Concept Check √

14. Classification of Elements: Assets NONCURRENT ASSETS Assets expected to provide economic benefits beyond the next year, or operating cycle  Investments  Property, Plant, and Equipment  Intangible Assets  Other Assets LO3- 2

15. Noncurrent Assets—PetSmart, Inc. LO3- 2 Noncurrent assets

16. Classification of Elements: Assets NONCURRENT ASSETS INVESTMENTS Assets not used directly in operations Examples Equity and debt securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes LO3- 2

17. Classification of Elements: Assets NONCURRENT ASSETS PROPERTY, PLANT, AND EQUIPMENT Tangible, long-lived assets used in the operations of the business Reported as a single amount in the balance sheet, at original cost less accumulated depreciation Examples Land, buildings, equipment, machinery, and furniture, as well as natural resources, such as mineral mines, timber tracts, and oil wells. LO3- 2

18. Classification of Elements: Assets NONCURRENT ASSETS INTANGIBLE ASSETS Generally represent exclusive rights Valuable resources in generating future revenues Reported in the balance sheet net of accumulated amortization Much of the value is not reported in the balance sheet Examples Patents, copyrights, and franchises LO3- 2

19. Classification of Elements: Assets NONCURRENT ASSETS OTHER ASSETS Include deferred charges and any noncurrent asset not included in one of the other classifications LO3- 2

20. Which of the following is most likely to be reported as a noncurrent asset: a.Accounts receivable b.Buildings c.Prepaid rent d.Inventories Concept Check √ Buildings generally benefit the company for several years. The other items listed above are generally realized as cash or consumed within one year.

21. LO3- 2 Which of the following represents tangible, long-lived assets used in the operations of the business? a.Current assets b.Investments c.Property, plant, and equipment d.Intangible assets Concept Check √ Current assets are not long-lived, investments are not used directly in operations, and intangible assets have no physical substance.

22. Classification of Elements: Liabilities CURRENT LIABILITIES Obligations expected to be satisfied through the use of current assets or the creation of other current liabilities Expected to be satisfied within one year or the operating cycle, whichever is longer Examples  Accounts and notes payable  Deferred revenues  Accrued liabilities  Current maturities of long-term debt LO3- 3

23. Classification of Elements: Liabilities CURRENT LIABILITIES ACCOUNTS PAYABLE Obligations to suppliers of merchandise or services purchased on account Payment usually due in 30 to 60 days NOTES PAYABLE Written promises to pay cash at some future date Usually require the payment of explicit interest in addition to the original obligation amount LO3- 3

24. Classification of Elements: Liabilities CURRENT LIABILITIES DEFERRED REVENUES Represent cash received from a customer for goods or services to be provided in a future period Example Purchase of a gift card ACCRUED LIABILITIES Represent obligations created when expenses have been incurred but will not be paid until a subsequent reporting period Examples Accrued salaries payable, accrued interest payable, and accrued taxes payable LO3- 3

25. Classification of Elements: Liabilities CURRENT LIABILITIES CURRENT MATURITIES OF LONG-TERM DEBT Example A $1,000,000 note payable requiring $100,000 in principal payments to be made in each of the next 10 years Examples Long-term notes, loans, mortgages, bonds payable, and long-term debt payable in installments LO3- 3 $1,000,000 $900,000 $100,000 Long-term liability Current liability

26. Classification of Elements: Liabilities LONG-TERM LIABILITIES Obligations that will not be satisfied in the next year or operating cycle, whichever is longer Do not require use of current assets or the creation of current liabilities for payment Impact on future cash flows and long-term solvency is assessed by reporting payment terms, interest rates, and other details in a disclosure note Examples  Long-term notes  Bonds  Pension obligations  Lease obligations LO3- 3

27. Liabilities—PetSmart, Inc. LO3- 3

28. The key distinction between current liabilities and long-term liabilities is: a.The amount of the obligation to be satisfied – large versus small. b.To whom the obligation is owed – those inside versus outside of the company. c.The length of time until the obligation is expected to be satisfied – Less than versus more than one year, or operating cycle if longer. d.The nature of the obligation – determinable amount versus estimated amount. Concept Check √

29. Classification of Elements: Shareholders’ Equity Arises primarily from (1) Paid-in capital and (2) Retained earnings Residual amount derived by subtracting liabilities from assets: Assets − Liabilities = Shareholders’ Equity Includes other equity components such as accumulated other comprehensive (loss) income LO3- 3

30. Shareholders’ Equity—PetSmart, Inc. LO3- 3 $ $ $ $

31. Financial Disclosures Convey additional information about account balances in basic financial statements Examples Allowance for uncollectible accounts and information about common stock LO3- 4 (1) By including additional information on the face of the statement following a financial statement item Financial statement disclosures are provided (2) In disclosure notes that often include supporting schedules

32. Disclosure Notes Explain data presented in financial statements themselves, or provide information not directly related to any specific item in the statements Examples Must include a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions LO3- 4 Pension plans Leases Long-term debt Income taxes Investments Property, plant, and equipment Employee benefit plan

33. Specific Disclosure Notes Summary of Significant Accounting Policies Conveys valuable information about a company’s choices from among various alternative accounting methods Subsequent Events Occurs after a company’s fiscal year end but before the financial statements are issued Examples Issuance of debt or equity securities Business combination or the sale of a business Sale of assets Event that sheds light on the outcome of a loss contingency LO3- 4

34. Specific Disclosure Notes Noteworthy Events and Transactions Related-party transactions Errors Fraud Illegal acts LO3- 4

35. Management Discussion and Analysis Provides a biased but informed perspective of a company’s: Operations Liquidity Capital resources Included in the annual reports of public companies Management’s Responsibilities Section Asserts the responsibility of management for the company’s annual report and internal control procedures Requires corporate executives to personally certify the financial statements as per the Sarbanes Oxley Act of 2002 LO3- 5

36. Auditors’ Report Provides the final statement user with an independent and professional opinion about: Fairness of the representations in the financial statements Effectiveness of internal controls Whether or not the financial statements are in conformity with generally accepted accounting principles Financial statements that “present fairly” the financial position prompt an unqualified opinion Sometimes circumstances cause the auditors’ report to include an explanatory paragraph in addition to the standard wording, even though the report is unqualified LO3- 6

37. Auditors’ Report Calls attention to problems that might exist in the financial statements Qualified opinion—contains an exception to the standard unqualified opinion Adverse opinion—results from (a) nonconformity with GAAP and (b) inadequate disclosures Disclaimer—results from limitation or restriction of the scope of the examination Assess firm’s ability to continue as a going concern Most informative in case of any deviations from standard unqualified opinion LO3- 6

38. Compensation of Directors and Top Executives Compensation gap between executives and lower- level employees is much wider in the United Statesthan in most other industrialized countries Historically, related disclosures were not clear Total compensation paid to executives led to confusion SEC requires corporations to provide for disclosures on compensation to directors and executives Proxy statement Contains disclosures on compensation to directors and executives Must be reported each year to all shareholders, along with annual report LO3- 6

39. Which disclosure provides an independent and professional opinion about the fairness of the representations in the financial statements and about the effectiveness of internal controls? a.Auditors’ report. b.Proxy statement. c.Management’s discussion and analysis. d.Summary of significant accounting policies. Concept Check √

40. Risk Analysis—Using Financial Statement Information Goal is to gain a glimpse of the future from past and present data using various tools and techniques Comparative financial statements Allow financial statement users to compare year-to- year financial position Help an analyst detect and predict trends Horizontal analysis Allow analysts to enhance their comparison by expressing each item as a percentage of that same item in the financial statements of another year Vertical analysis Involves expressing each item in the financial statements as a percentage of an appropriate corresponding total but within the same year LO3- 7

41. Risk Analysis—Using Financial Statement Information Ratio analysis Most common way of comparing accounting numbers to evaluate the performance and risk of a firm Allows analysts to control for size differences over time and among firms Default risk Concerned about a company’s ability to pay its obligations when they come due Operational risk Relates more to how adept a company is at withstanding various events that might impair its ability of earning profits LO3- 7

42. Liquidity Ratios Liquidity — refers to the readiness of assets to be converted to cash Common measures of liquidity are: Provide information about a company’s ability to pay its short-term obligations LO3- 8 Current ratio Current assets Current liabilities = Acid-test ratio (or quick ratio) Quick assets Current liabilities =

43. Current Ratio Relation between current assets and current liabilities Popular measure of a company’s ability to satisfy its short-term obligations Example: Consider that PetSmart has current assets of $1,318,243 and current liabilities of $794,345 at the end of its February 2, 2014, fiscal year. Working capital = Current Assets − Current Liabilities LO3- 8 Current ratio $1,318,243 $794,345 = 1.66 =

44. Acid-Test Ratio (Or Quick Ratio) Provides a more stringent indication of a company’s ability to pay its current obligations Numerator excludes inventories, prepaid items, restricted cash, and deferred taxes Numerator includes of unrestricted cash, short-term investments, and accounts receivable Example PetSmart's quick assets at the end of its February 2, 2014, fiscal year total $358,307. LO3- 8 Acid-test ratio $358,307 $794,345 = 0.45 =

45. LO3- 8 Which of the following transactions would increase a company’s liquidity ratios? a.Receive cash from customers on accounts receivable. b.Purchase office supplies with cash. c.Pay dividends to shareholders. d.Borrow cash by signing a three-year note. Concept Check √ Cash increases while current liabilities remain the same, thus increasing the company’s ability to pay existing short-term debt.

46. Financing Ratios Provide some indication of the riskiness of a company with regard to its ability to pay its long-term debts Common financing ratios are: LO3- 8 Debt to equity ratio Total liabilities Shareholders’ equity = Times interest earned ratio Net income + Interest expense + Income taxes Interest expense =

47. Debt to Equity Ratio Compares resources provided by creditors with resources provided by owners Indicates the extent of reliance on creditors, rather than owners Provides a measure of creditors’ protection in the event of insolvency Other things being equal: the higher the ratio the higher the risk LO3- 8

48. Debt to Equity Ratio Example PetSmart's liabilities at the end of its February 2, 2014, fiscal year total $1,428,186, and stockholders’ equity totals $1,093,782. Debt to equity ratio $1,428,186 $ 1,093,782 = 1.31 = LO3- 8

49. Debt to Equity Ratio More meaningful if compared to some standard such as an industry average or a competitor Example LO3- 8 Industry average debt to equity ratio 2.36 PetSmart’s debt to equity ratio 1.31 Indicates fewer liabilities in Petsmart’s capital structure than does the average firm in its industry >

50. LO3- 8 Geisner Inc. has total assets of $1,000,000 and total liabilities of $600,000. The industry average debt to equity ratio is 1.20. Calculate Geisner’s debt to equity ratio and indicate whether the company’s default risk is higher or lower than the average of other companies in the industry. a.0.60; Higher default risk. b.0.60; Lower default risk. c.1.50; Higher default risk. d.1.50; Lower default risk. Debt to equity ratio = $600,000 / $400,000* = 1.50 * Equity = Assets − Liabilities = $1,000,000 − $600,000 = $400,000 Concept Check √

51. Debt to Equity Ratio Relationship Between Risk and Profitability Higher the debt to equity ratio, higher the risk to shareholders Favorable financial leverage: Earning a return on borrowed funds that exceeds the cost of borrowing the funds LO3- 8

52. Favorable Financial Leverage LO3- 8 Income before interest and income taxes Less: Interest expense Income before income taxes Less: Income tax expense (40%) Net income $8,000,000 (800,000) (2,400,000) $7,200,000 $5,600,000 (2,880,000) (2,240,000) $4,320,000 $3,360,000 Return on shareholders’ equity $4,320,000 $40,000,000 $3,360,000 $20,000,000 Alternative 1 Alternative 2 Alternative 1 Alternative 2 = = 10.8% 16.8% A newly formed corporation is attempting to determine the appropriate mix of debt and equity. The initial capitalization goal is $50 million. The capitalization mix alternatives have been narrowed to two: (1) $10 million in debt and $40 million in equity and (2) $30 million in debt and $20 million in equity. Income before interest and taxes will be $8 million. The interest rate on debt is 8% and the income tax rate is 40%. Calculate the net income and return on shareholders’ equity for both alternatives. 10,000,000 × 8% 30,000,000 × 8%

53. Unfavorable Financial Leverage LO3- 8 Income before interest and income taxes Less: Interest expense Income before income taxes Less: Income tax expense (40%) Net income $3,000,000 (800,000) (2,400,000) $2,200,000 $600,000 (880,000) (240,000) $1,320,000 $360,000 Return on shareholders’ equity $1,320,000 $40,000,000 $360,000 $20,000,000 Alternative 1 Alternative 2 Alternative 1 Alternative 2 = = 3.3% 1.8% A newly formed corporation is attempting to determine the appropriate mix of debt and equity. The initial capitalization goal is $50 million. The capitalization mix alternatives have been narrowed to two: (1) $10 million in debt and $40 million in equity and (2) $30 million in debt and $20 million in equity. Income before interest and taxes will be $3 million. The interest rate on debt is 8% and the income tax rate is 40%. Calculate the net income and return on shareholders’ equity for both alternatives. 10,000,000 × 8% 30,000,000 × 8%

54. Times Interest Earned Ratio Indicates the margin of safety provided to creditors Designed to measure the ability of a company to satisfy its fixed debt obligations Example: PetSmart's financial statements for the fiscal year ended February 2, 2014, report: LO3- 8 ($ in thousands) $419,520 52,479 239,444 $711,443 Times interest earned ratio $711,443 $52,479 = 13.6 = Income before interest and taxes Income taxes Interest expense Net income

55. International Financial Reporting Standards LO3- 9 U.S. GAAPIFRS Balance Sheet Presentation No minimum requirementsSpecifies a minimum list of items to be presented in the balance sheet Some companies use the statement of financial position title Changed the title of balance sheet to statement of financial position, although companies are not required to use that title Current assets and liabilities are presented before noncurrent assets and liabilities Balance sheets often report noncurrent items first Segment Reporting Requires companies to report information about reported segment profit or loss, including certain revenues and expenses, segment assets, and the basis of measurement. Along with items included in U.S. GAAP, it requires that companies also disclose total liabilities of its reportable segments.

56. Reporting by Operating Segment Facilitates the financial statement analysis of diversified companies WHAT IS A REPORTABLE OPERATING SEGMENT? Determined by using a management approach Evident from the structure of the enterprise’s internal organization Component of an enterprise—formally defined by characteristics: Engages in business activities from which it may recognize revenues and incur expenses Whose operating results are regularly reviewed by the enterprise’s chief operating decision maker For which discrete financial information is available APPENDIX 3

57. What Amounts Are Reported by an Operating Segment? Required disclosures: General information about the operating segment Information about reported segment profit or loss, including certain revenues and expenses included in reported segment profit or loss, segment assets, and the basis of measurement Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items to corresponding enterprise amounts Interim period information APPENDIX 3

58. Business Segment Information Disclosure— Abbott Laboratories, Inc. APPENDIX 3

59. Reporting by Geographic Area U.S. GAAP requires an enterprise to report certain geographic information: Revenues from external customers Long-lived assets other than financial instruments, long-term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets APPENDIX 3

60. Information About Major Customers Helps the financial analysts in providing information concerning the extent to which a company’s prosperity depends on one or more major customers If 10% or more of the revenue of an enterprise is derived from transactions with a single customer, the facts must be disclosed by the company APPENDIX 3

61. End of Chapter 3