Published on July 21, 2009
The Balance Sheet and Notes to the Financial Statements : The Balance Sheet and Notes to the Financial Statements S t I c e | S t I c e | S k o u s e n Learning Objectives : Learning Objectives Describe the specific element of the balance sheet (assets, liabilities, and owners’ equity), and prepare a balance sheet with assets and liabilities properly classified into current and noncurrent categories. Identify the different formats used to present balance sheet data. Analyze a company’s performance and financial position through the computation of financial ratios. Learning Objectives (cont.) : Learning Objectives (cont.) Recognize the importance of the notes to the financial statements and outlined the types of disclosures made in the notes. Understand the major limitations of the balance sheet. The Balance Sheet : The Balance Sheet Presents a listing of an organization’s assets and liabilities at a certain time point. The difference between assets and liabilities is called equity. Represented by the basic accounting equation: Assets = Liabilities + Owners’ Equity Elements of the Balance Sheet : Assets Probable future economic benefit obtained or controlled by a particular entity as a result of past transactions or events Elements of the Balance Sheet The inclusion of “probable” acknowledges that accounting is not an exact science The primary purpose of the balance sheet is to help forecast the future. If a company economically controls the future economic benefits associated with an item, that item qualifies as an asset- even if legally it is not owned. Elements of the Balance Sheet : Elements of the Balance Sheet “Obligation” includes legal, moral, social, and implied commitments. An obligation to provide services is also a liability. Assets and liabilities arise from past events. Liability Probable future sacrifice of economical benefit arising from a present obligation of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Stop & Think : Stop & Think Alternatively, asset could be defined as everything legally owned by a company, and liability defined as all legal obligations. Which ONE of the following would NOT be a problem of these legalistic definitions. How to Classify Items on the Balance Sheet : How to Classify Items on the Balance Sheet Current (less than 1 year) Noncurrent (more than 1 year) Order of liquidity Historical cost Working capital = CA - CL It is the liquid buffer available in meeting financial demands and contingencies of the near future. Current Assets : Current Assets Cash and resources expected to be converted to cash during the entity’s normal operating cycle or one year, whichever is longer, are current assets. Cash Trading Securities Accounts Receivables Inventories Prepaid Assets Operating Cycle : Operating Cycle Receivables Cash Inventories Purchases Collections Sales Noncurrent Assets : Noncurrent Assets Investments Property, plant, and equipment Intangible Assets Deferred income taxes Plant, Property, and Equipment : Plant, Property, and Equipment Intangible Assets : Intangible assets are long-term rights and privileges of a nonphysical nature acquired for use in business operations. Intangible Assets Current Liabilities : Current liabilities are obligations expected to be paid using current assets or by creating other current liabilities. Accounts and notes payable Accrued expenses Current portion of long-term obligations Unearned revenues Generally, if a liability is expected to be paid within 12 months, it is classified as current as long as it is paid within the operating cycle. Current Liabilities Callable Obligations : If the terms of the agreement for a callable obligation is due on demand or will become due on demand within one year from the balance sheet date, the obligation should be classified as current. Callable Obligations Noncurrent Liabilities : Noncurrent Liabilities Current liabilities do not usually include: Debts to be liquidated from a noncurrent sinking fund. Sinking fund- cash and investment securities that have been accumulated for payment of a specific loan. Short-term obligations to be refinanced. Noncurrent Liabilities : Noncurrent Liabilities Long-term debt Long-term lease obligations Deferred income tax liability Pension obligations Noncurrent Liabilities : Noncurrent Liabilities Long-term debt is reported at its discounted present value. When a note, bond issue, or a mortgage becomes payable within a year, it should be reclassified as a current liability. For a capital lease, the present value of the future minimum payments is recorded as long-term liability. Most large companies include deferred taxes liabilities on the balance sheet. Contingent Liabilities : Contingent Liabilities Past activities or circumstances may give rise to possible future liabilities. Contingent liabilities- Potential obligations that do not exist on the balance sheet date. An estimated liability is a definite liability, so it is not a contingent liability. Stop & Think : Stop & Think The current/noncurrent classification scheme is only one way to split assets and liabilities into two groups. Below are three alternate 2-way classification schemes. Which one would be most useful for: (1) A financial analyst trying to compare the company’s core business with the core businesses of similar companies? (2) A U.S. congressperson concerned about the relocation of operations overseas? (3) An analyst trying to estimate the current market value of a company? Owners’ Equity : Owners’ Equity Can also be called stockholders’ or shareholders equity. Generally divided into two parts: Contributed capital also known as paid-in-capital Retained Earnings Contributed Capital : Contributed Capital Two parts of contributed capital: Capital Stock- the number of shares x the par value. Preferred stock- usually paid a fixed annual cash dividend and have rights to their investment in bankruptcy Common stock- real owners of the corporation, have voting power, but are last in line for assets in bankruptcy Additional paid-in capital- investment by shareholders in excess of par value of capital stock. Retained Earnings : Retained Earnings Retained Earnings (RE)- the amount of undistributed earnings of past periods. RE Deficit- an excess of dividends and losses over earnings results in a negative retained earnings balance. Sometimes, RE is restricted and unavailable for cash dividends. Treasury Stock : Treasury Stock Treasury Stock- when a company buys back its own shares. Treasury shares can be retired, or they can be retained and reissued later. X Corporation Common Stock Par $10 Other Equity : Other Equity The FASB requires companies to summarize changes in owners’ equity exclusive of net income and contributions by and distributions to owners. Unrealized gains and losses on available-for-sale securities are shown as a separate equity item. Adjustments arising from the change in the equity of foreign subsidiaries (as measured in U.S. dollars) resulting from changes in foreign currency exchange rates are shown in the equity section. Some of the unrealized gains and losses from the fluctuations in the value of derivatives are reported as part of accumulated other comprehensive income. Format of the Balance Sheet : Format of the Balance Sheet Generally, assets and liabilities are presented in their order of liquidity. Some industries with significant investments in land and buildings will list these items first on the balance sheet. Generally, a balance sheet is presented in comparative form, including data from both the current year and the previous year. Foreign balance sheets frequently list the current assets and current liabilities together. Balance Sheet Analysis : Balance Sheet Analysis Balance sheet information is analyzed two ways: Relationships between balance sheet amounts Relationships between balance sheet and income statement amounts. Financial ratios show the relationships between financial statement amounts. Liquidity : Liquidity Liquidity- the ability of a firm to satisfy its short-term obligations. Two common measures of liquidity: Current ratio = Current Assets Current Liabilities Quick ratio = Quick Assets Current Liabilities Liquidity Ratio Example : Cash $ 30 Net Accounts Receivable 70 Inventory 100 Current Assets $200 Current Liabilities 100 = 2:1 Current Ratio Liquidity Ratio Example Liquidity Ratio Example : Cash $ 30 Net Accounts Receivable 70 Inventory 100 Current Assets $200 Current Liabilities 100 = 1:1 Cash $ 30 Net Accounts Receivable 70 Inventory 100 Current Assets $200 Current Liabilities 100 Quick Ratio Liquidity Ratio Example Overall Leverage : Overall Leverage Debt Ratio- total liabilities divided by total assets. Total Assets $400 Total Liabilities 300 = 75% Efficiency : Efficiency Asset Turnover- measures how efficiently a company uses its assets to generate sales. Sales $200 Total Assets 400 = 0.50 Profitability : Profitability Net Income $ 40 Total Assets 400 Stockholders’ Equity 160 = 10.0% Return on Assets Two ratios that measure profitability: Return on Assets Return on Equity Profitability : Profitability Net Income $ 40 Total Assets 400 Stockholders’ Equity 160 = .25% Return on Equity Two ratios that measure profitability: Return on Assets Return on Equity Selected 2004 Ratios : Selected 2004 Ratios Typical Notes to the Financial Statements : Typical Notes to the Financial Statements Summary of significant accounting policies. Additional information to support summary totals. Information that fails to meet recognition criteria for statements, but is important for users. Supplementary information required by the FASB or SEC to adhere to full disclosure principle. Subsequent Events : Subsequent Events Financial Statement Period Events in this period may affect the reporting of events in this period. Balance Sheet Date Date Statements Issued Subsequent Period Subsequent Events : Subsequent Events Financial Statement Period Subsequent Period Balance Sheet Date Date Statements Issued Types of Events: Ones that materially affect one or more financial statements. Ones that create a need for a footnote. Stop & Think : Stop & Think Which one of the three subsequent events disclosed by AT&T as occurring in 2005 would require an adjustment of the 2004 financial statements?