Balance Sheet and Statement of Cash Flow

7/29/2019 Balance Sheet and Statement of Cash Flow

1/21

Page 1 of 21

Chapter 5: Balance Sheet and Statement of Cash Flow

Balance Sheet: Financial position of a firm at a particular point in time;

Provides information about the nature and amounts of investments in enterprise

resources, obligations to creditors, and the owners equity in net resources.

Helps predict amounts, timing, and uncertainty of future cash flows.

1) Usefulness of the Balance Sheet: The balance sheet is useful for analyzing a

companys liquidity, solvency, and financial flexibility.

a Liquidity: How quickly assets can be converted into cash.

b Solvency: How easily a company can pay its debt.

c Financial Flexibility: Ability to alter amounts and timing of cash flows as

necessary.

2) Limitations of the Balance Sheet:

a

In other words, the Balance Sheet information is highly reliable but not

necessarily as relevant.

b

c

(e.g., employees knowledge and skill, customer base, research superiority, and

reputation.) Also, some company obligations are omitted (e.g., certain types of

lease arrangements.)


2/21

Page 2 of 21

3) Classification in the Balance Sheet:

a General:

i) Balance Sheet Classification: similar items are grouped together to arrive at

significant subtotals.

ii) Report individual items separately. Such detail allows users to better assess

the amounts, timing, and uncertainty of future cash flows. (For example, if a

user can see the individual amount of Accounts Receivable, he can estimate

the amount of cash to be received in the next year from current year A/R.) It

also helps in evaluating liquidity and financial flexibility, profitability, and

risk. (For example, a user can estimate liquidity by observing individual debt

amounts.)

iii) The three general classes of items included in the balance sheet are:

(1) Assets: Probable future economic benefits owned or controlled by the

entity. Assets include:

(a)

(b)

(c)

(d)

(e)

(2) Liabilities: Probable future sacrifices of economic benefit (results from

past transactions or events.) Liabilities include:

(a)

(b)


3/21

Page 3 of 21

(3) Equity: Residual interest (i.e., what is left over) in the assets of an entity

that remains after deducting its liabilities. Owners Equity includes:

(a)

(i)

(ii)

(b)

(c)

(d)

(e)

(Note: Items listed in each section above are not all-inclusive;

however, they are typical of almost all Balance Sheets.)

b Current Assets:

Some exceptions exist: Example: Investment in common stock is classified as

either a current asset or a non-current asset depending on managements intent.

Investments in small holdings of common stocks or bonds that are going to be

held for a long period of time.

Operating Cycle:


4/21

Page 4 of 21

Current Assets are presented in the balance sheet _________________________.

Each section is presented below in the __________________________________.

(Note: These 5 items are notconsidered current assets ifthey are not expected to

be realized in one year or in the operating cycle, whichever is longer.)

i) Cash:

(1) Valuation:

(2) Must disclose any restrictions. Depending on the circumstances, restricted

cash may be in current assets or non-current assets. See Illustration 5-2 on

page 173.

ii) Short-Term Investments:

(1) Valuation:

(2) Investments in debt and equity securities are grouped into three separate

portfolios for valuation and reporting purposes.

(a) Held-to-maturity: Debt securities intended to be held to maturity

(e.g., hold a bond until it expires.) Classified as current or non-current

depending on the circumstances.

(b) Trading: Debt and equity securities expected to be sold in the near

future.


5/21

Page 5 of 21

(c) Available-for-sale: Debt and equity securities not classified as held-

to-maturity or trading securities. Classified as current or non-current

depending on the circumstances.

iii) Receivables:

(1) Valuation:

(2) Clearly identify any anticipated loss due to uncollectible accounts, the

amount and nature of any non-trade receivables, and any receivables

designated or pledged as collateral.

iv) Inventories:

(1) Valuation:

(2) Must disclose valuation basis (i.e., lower of cost or market LCM) and

pricing method (e.g., FIFO, LIFO, etc.) Also, the stage of completion of

manufactured inventories should be disclosed (i.e., Raw Materials, WIP,and Finished Goods.) See Illustrations 5-7 on page 176.

v) Prepaid Expenses:

(1) Valuation:

(2) Expenditures already made for benefits (usually services) to be received

within one year or the operating cycle, whichever is longer.

(3) Include as current assets even though they do not technically meet the

definition of a current asset; never convert into cash or used to pay a

liability, just use up.

(4) Insurance and other prepayments for longer than one year are often

included in current assets even though part of the advance payment applies


6/21

Page 6 of 21

to periods beyond one year or the current operating cycle. (Could also be

included in other asset section as deferred charge.)

(5) Examples:

c Non-Current Assets:

i) Long-Term Investments: Investments held for many years. Not acquired

with the intention of selling in the near future.

(1) Investments normally consisting of one of four types:

(a) Investments insecurities

Why hold these?

(b) Investments in tangible fixed assets not currently used in operations.

(c) Investments set aside inspecial funds such as

(d) Investments in non-consolidated subsidiaries or affiliated companies.


7/21

Page 7 of 21

(2) Depending on managements intent, classified as either Available-for-Sale

or Held to Maturity.

ii) Property, Plant, and Equipment: Tangible, long-term fixed assets acquired

for use in main operations. (In practice, a detailed classification of PPE is

disclosed in a supplementary schedule rather than on the face of the balance

sheet.)

(1) Land :

(2) Buildings, equipment, furniture, fixtures :

(If equipment is held for sale, include it separately in the current asset

section or include it in the investment section.)

(3) Natural Resources :

(4) Capitalized leases :

iii) Intangible Assets: IA have no physical substance but they convey value

because of ownership rights.

(1) Examples:

(a)

(b)

(c)


8/21

Page 8 of 21

(d)

(2) Reporting:

(a) Limited-life intangibles are written off (amortized using straight-line

method) over their useful lives.

(b) Indefinite-life intangibles (e.g., goodwill) are not amortized, but are

periodically assessed for impairment.

(c) Expenditures for intangible assets such as most R&D (Research and

Development) and internally-developed goodwill are not capitalized

but are expensed as incurred.)

iv) Other Assets:

(1) Examples: Deferred charges (long-term prepaid expenses), non-current

receivables, intangible assets, assets in special funds, deferred income

taxes.

(2) Section tends to be too general. It should be restricted to unusual items

sufficiently different from assets included in special categories.

v) Classification of Assets: Depends on the nature of item and the use of item.

Forexample:

(1) Land used as factory site

(2) Land owned by a realty company and held for sale

(3) Land held for speculation

(4) Idle land and facilities that have been withdrawn from production

d Liabilities:

i) Current Liabilities (CL):


9/21

Page 9 of 21

(1) Obligations expected to be settled using current assets or creating current

liabilities.

(2) Examples:

(a) Payables resulting from acquiring goods and services (e.g., accounts

payable, wages payable, taxes payable.)

(b) Unearned Revenue: Collections received in advance for delivery of

goods or performance of services.

(c) Other liabilities whose liquidation will take place within the operating

cycle (e.g., portion of long-term bonds payable in current year, short-

term obligations arising from equipment purchase.)

(3) Current Liabilities are not reported in a consistent order. However, they

are frequently reported in the order they will be paid.

(4) Some liabilities that will be paid within a year are reported as long-term

liabilities. These include:

(a) If debt is refinanced through another long-term debt issuance

(b) If debt is retired out of non-current assets.

(5) Working Capital:


10/21

Page 10 of 21

ii) Long-Term Liabilities:

(1) Obligations that are not reasonably expected to be liquidated within the

normal operating cycle.

(2) Examples:

(a) Obligations from Specific Financing:

(i)

(ii)

(iii)

(iv)

(b) Obligations from Ordinary Operations:

(i)

(ii)

(c) Obligations dependent on the occurrence and outcome of future

events:

(i)

(ii)


11/21

Page 11 of 21

(3) The currently maturing portion of long-term debt is classified as a current

liability.

(4) Supplementary Information Typically Disclosed: Debt

covenants/restrictions; maturity dates; interest rates; amount of securities

pledged to support debt.

e Owners Equity:

i) General:

(1) Contributed Capital (i.e., Capital Stock):

(a)

(b)

(c)

(d)

Can have APIC for Preferred Stock, Common Stock, Common Stock

Subscribed, and Treasury Stock. (These amounts can be presented as

one total sum or as individual amounts.)

(2) Retained Earnings: Accumulated earnings of the company over its life

less any dividends distributed to stockholders. This section may be

divided between unappropriated (amount available fore dividend

distribution) and any amounts that are restricted (e.g., bond indentures or

other loan agreements.)


12/21

Page 12 of 21

(3) Accumulated Other Comprehensive Income: See Chapter 4. If amount

represents income (loss), it is an addition (subtraction).

(4) Treasury Stock

ii) Must disclose capital stock authorized, issued, and outstanding par value

amounts.

f Balance Sheet Format:

i) Account form: Lists assets by sections on the left side, and liabilities and

stockholders equity by sections on the right side.

ii) Report form: Lists liabilities and stockholders equity directly below assets

on the same page. (See Illustration 5-15 on page 182.)


13/21

Page 13 of 21

iii) Example following report form format:

Company Name

Balance SheetDecember 31, 20xx

AssetsCurrent Assets

Cash

Receivables

Inventory

Prepaid Expenses

Total current assets

Long-Term InvestmentsAvailable for sale securities

Property, plant, and equipment

Land at cost

Buildings at costLess: Accumulated depreciation

Equipment at cost

Less: Accumulated depreciationTotal property, plant, and equipment

Intangible assetsGoodwill

Total assets


14/21

Page 14 of 21

Liabilities and Stockholders Equity

Current liabilities

Accounts payable

Notes payable

Income taxes payableAccrued liabilities

Total current liabilities

Long-term Liabilities

Bonds Payable

Long Term DebtDeferred income taxes

Total liabilities

Stockholders equity

Preferred Stock

Common Stock

APIC

Retained EarningsAccumulated other comprehensive income

Total stockholders equity

Total liabilities and stockholders equity


15/21

Page 15 of 21

g Altmans Z-score: This is a bankruptcy-prediction model that can be used tohelp evaluate the overall financial position and trends of a firm.

6).99.0

3.34.1Re

2.1

++

++=

litiesTotalLiabi

MVEquity

sTotalAsset

SalessTotalAsset

EBIT

sTotalAsset

ingstainedEarn

sTotalAsset

italWorkingCapZ

Companies with z-scores above 3.0 are unlikely to fail. Companies with z-scores

below 1.81 are very likely to fail.

(I doubt that I will test you on this but you should be aware of this model when

you are practicing accounting.)

4) Additional Information Reported:

a Contingencies: Material events that have an uncertain outcome. (Examples:

Uncertain gains/losses from litigation; uncertain gains/losses from environmental

issues; uncertain gains/losses from on-going governmental investigations.)

Include as Long Term Liability if loss is probable and estimable.

b Accounting Policies:

i) Describe all significant accounting principles and methods that involveselection from among alternatives and/or those that are peculiar to a given

industry.

ii) Disclose information about nature of operations, use of estimates in preparing

financial statements, certain significant estimates, and vulnerabilities due to

certain concentrations. (That is, disclose information about risks and

uncertainties involved in operations.)

iii) This information is typically given in a Summary of Significant Accounting

Policies. This note either precedes the footnotes or is the first footnote. (I

have always seen this as the first footnote.) See Procter & Gamble example,

Note 1, page 211 to 213.


16/21

Page 16 of 21

c Contractual Situations: Significant contractual situations should be disclosed in

financial statement notes.

i) It is MANDATORY to disclose provisions of lease contracts, pension

obligations, and stock option plans in the notes.

ii) Commitments related to obligations to maintain working capital, to limit the

payment of dividends, to restrict the use of assets, and to require the

maintenance of certain financial ratios must all be disclosed if material.

iii)

d Fair Values: Financial Instruments: Cash, an ownership interest, or a

contractual right to receive or obligation to deliver cash or another financial

instrument.

i) Can be either assets or liabilities:

ii) Both carrying value and estimated fair value of financial instruments must be

disclosed. (See Illustration 5-18 on page 187.)

5) Techniques of Disclosure:

a Parenthetical Explanations:

b Notes:

c Cross Reference and Contra Items:

Remember, a contra account on a balance sheet is

An adjunct account


17/21

Page 17 of 21

d Supporting Schedules:

e Terminology: Use of the term surplus is discouraged. The term reserve

should be used only to describe an appropriation of retained earnings.

6) Purpose of the Statement of Cash Flows:

a Remember that assessing the amounts, timing, and uncertainty of cash flows

was presented as one of the three basic objectives of financial reporting in

Chapter 2. The Statement of Cash Flow helps meet this objective. It is a required

statement.

b Purposes of Statement :

i) Primary Purpose:

ii) To summarize the operating, investing, and financing activities of the

business.

c Reporting sources, uses, and net increase/decrease in cash helps investors,

creditors, and others know what is happening to a companys most liquid

resource. This statement provides answers to the following questions:

i)

ii)

iii)


18/21

Page 18 of 21

d Helps evaluate liquidity, solvency, and financial flexibility.

i) Liquidity:

ii) Solvency:

iii) Financial Flexibility:

7) Content and Format of the Statement of Cash Flows:

Cash receipts and cash payments during a period are classified in the statement of

cash flows into three different activities operating, investing, and financing

activities.

a Operating activities:

b Investing activities:

Specific Examples:


19/21

Page 19 of 21

c Financing activities:

Specific Examples:

d Basic Format: Illustration 5-24, page 192

HEADING

Cash flows from operating activities

Cash flows from investing activities

Cash flows from financing activities

Net increase (decrease) in cash

Cash at beginning of year

Cash at end of year

8) Preparation of the Statement of Cash Flows:

a Info needed to prepare CF Stmt comes from:

i)

ii)

iii)


20/21

Page 20 of 21

b In preparing CF Stmt, one must:

i) Determine cash provided by operations.

ii) Determine cash provided by/used in investing and financing activities.

iii) Determine change in cash during period.

iv) Reconcile change in cash with beginning and ending cash balances.

c Cash from Operations: The excess of cash receipts over cash payments.

Determined by converting net income on an accrual basis to a cash basis. This is

accomplished by adding to or deducting from net income those items in the

income statement not affecting cash. This procedure requires an analysis not only

of the current years income statement but also of the comparative balance sheets

and selected transaction data.

Formula:

d See Illustration 5-30, Comprehensive Statement of Cash Flows on page 195.

e Significant non-cash transactions:

i) All significant financing and investing activities must be disclosed in the CF

statement or notes, even though cash is not affected.


21/21

Page 21 of 21

ii) Examples:

(1)

(2)

9) Usefulness of the Statement of Cash Flows:

For small and newly developing companies, cash flow is the single most important

element for survival. Even medium and large companies indicate a major concern in

controlling cash flow.

Companies can fail even tough they are profitable. Net income and net cash provided

by operating activities can be substantially different.

The reasons for the difference between a positive net income and a negative net cash

provided by operating activities are substantial increases in receivables and/or

inventories.

a Financial Liquidity:

b Financial Flexibility:

c Free Cash Flow:

Documents

Balance Sheet and Statement of Cash Flow