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1 Practical Issues related to Balance Sheet and Statement of Cash Flow Instructor Adnan Shoaib PART II: Corporate Accounting Concepts and Issues Lecture 07 Slide 2 2 1. 1.Explain the uses and limitations of a balance sheet. 2. 2.Identify the major classifications of the balance sheet. 3. 3.Prepare a classified balance sheet using the report and account formats. 4. 4.Indicate the purpose of the statement of cash flows. 5. 5.Identify the content of the statement of cash flows. 6. 6.Prepare a statement of cash flows. 7. 7.Understand the usefulness of the statement of cash flows. 8. 8.Determine which balance sheet information requires supplemental disclosure. 9. 9.Describe the major disclosure techniques for the balance sheet. Learning Objectives Slide 3 3 Balance Sheet Additional Information Usefulness Limitations Classification Supplemental disclosures Techniques of disclosure Balance Sheet and Statement of Cash Flows Statement of Cash Flows Purpose Content and format Preparation Usefulness Slide 4 4 Balance Sheet, also referred to as the statement of financial position: 1.Reports assets, liabilities, and equity at a specific date. 2.Provides information about resources, obligations to creditors, and equity in net resources. 3.Helps in predicting amounts, timing, and uncertainty of future cash flows. Balance Sheet LO 1 Explain the uses and limitations of a balance sheet. Slide 5 5 Computing rates of return. Evaluating the capital structure. Assess risk and future cash flows. Analyze the companys: Liquidity, Solvency, and Financial flexibility. Balance Sheet Usefulness of the Balance Sheet LO 1 Explain the uses and limitations of a balance sheet. Slide 6 6 Most assets and liabilities are reported at historical cost. Use of judgments and estimates. Many items of financial value are omitted. Limitations of the Balance Sheet Balance Sheet LO 1 Explain the uses and limitations of a balance sheet. Slide 7 7 Classification LO 2 Identify the major classifications of the balance sheet. Balance Sheet Slide 8 8 Illustration 5-1 In practice you usually see little departure from these major subdivisions. Balance Sheet Classification LO 2 Identify the major classifications of the balance sheet. Slide 9 9 Cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer. Current Assets Classification in the Balance Sheet Illustration 5-2 LO 2 Identify the major classifications of the balance sheet. Slide 10 10 Generally any monies available on demand. Cash equivalents - short-term highly liquid investments that mature within three months or less. Restrictions or commitments must be disclosed. Cash LO 2 Illustration 5-3 Balance Sheet Current Assets Slide 11 11 Illustration 5-4 Balance SheetRestricted Cash Cash LO 2 Identify the major classifications of the balance sheet. Balance Sheet Current Assets Slide 12 12 PortfoliosTypeValuationClassification Held-to- Maturity Debt Amortized Cost Current or Noncurrent Trading Debt or Equity Fair ValueCurrent Available- for-Sale Debt or Equity Fair Value Current or Noncurrent Short-Term Investments LO 2 Identify the major classifications of the balance sheet. Balance Sheet Current Assets Slide 13 13 Illustration 5-5 Balance Sheet Presentation of Investments in Securities Short-Term Investments LO 2 Identify the major classifications of the balance sheet. Balance Sheet Current Assets Slide 14 14 Major categories of receivables should be shown in the balance sheet or the related notes. A company should clearly identify Anticipated loss due to uncollectibles. Amount and nature of any nontrade receivables. Receivables used as collateral. Receivables LO 2 Identify the major classifications of the balance sheet. Balance Sheet Current Assets Slide 15 15 Receivables Illustration 5-6 Balance Sheet Presentation of Receivables LO 2 Identify the major classifications of the balance sheet. Balance Sheet Current Assets Slide 16 16 Inventories Disclose: Basis of valuation (e.g., lower-of-cost-or-market). Cost flow assumption (e.g., FIFO or average cost). LO 2 Illustration 5-6 Balance Sheet Current Assets Slide 17 17 Payment of cash, that is recorded as an asset because service or benefit will be received in the future. insurance supplies advertising Cash Payment Expense Recorded BEFORE rent taxes Prepayments often occur in regard to: Prepaid Expenses LO 2 Identify the major classifications of the balance sheet. Balance Sheet Current Assets Slide 18 18 Prepaid Expenses Illustration 5-9 LO 2 Identify the major classifications of the balance sheet. Balance Sheet Current Assets Slide 19 19 Current Assets - Summary Cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer. LO 2 Identify the major classifications of the balance sheet. Balance Sheet Current Assets Slide 20 20 Long-term Investments 1.Securities (bonds, common stock, or long-term notes). 2.Tangible fixed assets not currently used in operations (land held for speculation). 3.Special funds (sinking fund, pension fund, or plant expansion fund. 4.Non-consolidated subsidiaries or affilated companies. Classification in the Balance Sheet Non-Current Assets LO 2 Identify the major classifications of the balance sheet. Slide 21 21 PortfoliosTypeValuationClassification Held-to- Maturity Debt Amortized Cost Current or Noncurrent Trading Debt or Equity Fair ValueCurrent Available- for-Sale Debt or Equity Fair Value Current or Noncurrent Balance Sheet Noncurrent Assets Long-Term Investments LO 2 Identify the major classifications of the balance sheet. Slide 22 22 Long-Term Investments SecuritiesSecurities bonds, stock, and long-term notes For marketable securities, managements intent determines current or noncurrent classification. LO 2 Balance Sheet Noncurrent Assets Slide 23 23 Long-Term Investments Balance Sheet Noncurrent Assets Fixed Assets Land held for speculation LO 2 Slide 24 24 Long-Term Investments Balance Sheet Noncurrent Assets Special Funds Sinking fund Pensions fund Cash surrender value of life insurance LO 2 Slide 25 25 Long-Term Investments Balance Sheet Noncurrent Assets Nonconsolidated Subsidiaries or Affiliated Companies LO 2 Slide 26 26 Long-Term Investments Illustration 5-10 Balance Sheet Presentation of Long-Term Investments LO 2 Identify the major classifications of the balance sheet. Balance Sheet Noncurrent Assets Slide 27 27 Tangible long-lived assets used in the regular operations of the business. Physical property such as land, buildings, machinery, furniture, tools, and wasting resources (minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., oil reserves) these assets. Property, Plant, and Equipment LO 2 Identify the major classifications of the balance sheet. Balance Sheet Noncurrent Assets Slide 28 28 LO 2 Identify the major classifications of the balance sheet. Property, Plant, and Equipment Balance Sheet Noncurrent Assets Tangible assets used in the regular operations of the business. Slide 29 29 Illustration 5-11 Balance Sheet Presentation of Property, Plant, and Equipment LO 2 Identify the major classifications of the balance sheet. Balance Sheet Noncurrent Assets Slide 30 30 Balance Sheet Noncurrent Assets Intangibles Lack physical substance and are not financial instruments. Limited life intangibles amortized. Indefinite-life intangibles tested for impairment. LO 2 Slide 31 31 Intangibles (BE5-6): Patrick Corporation adjusted trial balance contained the following asset accounts at December 31, 2012: Prepaid Rent $12,000; Goodwill $50,000; Franchise Fees Receivable $2,000; Franchises $47,000; Patents $33,000; Trademarks $10,000. Prepare the intangible assets section of the balance sheet. Intangibles Goodwill $ 50,000 Franchises 47,000 Patents 33,000 Trademarks 10,000 Total $140,000 LO 2 Identify the major classifications of the balance sheet. Balance Sheet Noncurrent Assets Slide 32 32 Intangible Assets Illustration 5-12 Balance Sheet Presentation of Intangible Assets LO 2 Identify the major classifications of the balance sheet. Balance Sheet Noncurrent Assets Slide 33 33 Items vary in practice. Can include: Long-term prepaid expenses Non-current receivables Assets in special funds Property held for sale Restricted cash or securities Other Assets LO 2 Identify the major classifications of the balance sheet. Balance Sheet Noncurrent Assets Slide 34 34 Balance Sheet Noncurrent Assets Other Assets This section should include only unusual items sufficiently different from assets in the other categories. LO 2 Slide 35 35 Obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities. Classification in the Balance Sheet Current Liabilities LO 2 Identify the major classifications of the balance sheet. Slide 36 36 Current Liabilities Illustration 5-13 Balance Sheet Presentation of Current Liabilities LO 2 Identify the major classifications of the balance sheet. Classification in the Balance Sheet Slide 37 37 Obligations that a company does not reasonably expect to liquidate within the normal operating cycle. All covenants and restrictions must be disclosed. Long-Term Liabilities LO 2 Identify the major classifications of the balance sheet. Classification in the Balance Sheet Slide 38 38 Long-Term Liabilities (BE5-9): Included in Adams Companys December 31, 2012, trial balance are the following accounts: Accounts Payable $220,000; Pension Asset/Liability $375,000; Discount on Bonds Payable $29,000; Unearned Revenue $41,000; Bonds Payable $400,000; Salaries and Wages Payable $27,000; Interest Payable $12,000; Income Taxes Payable $29,000. Prepare the long-term liabilities section of the balance sheet. Long-term liabilities Pension Asset/liability $375,000 Bonds payable 400,000 Discount on bonds payable (29,000) Total 746,000 LO 2 Identify the major classifications of the balance sheet. Balance Sheet Long-Term Liabilities Slide 39 39 Non-Current Liabilities Illustration 5-14 Balance Sheet Presentation of Non-Current Liabilities LO 2 Identify the major classifications of the balance sheet. Balance Sheet Long-Term Liabilities Slide 40 40 Owners Equity LO 2 Identify the major classifications of the balance sheet. Balance Sheet Owners Equity Slide 41 41 Illustration 5-15 Balance Sheet Presentation of Stockholders Equity Owners Equity LO 2 Identify the major classifications of the balance sheet. Balance Sheet Owners Equity Slide 42 42 (a)Investment in preferred stock Classification in the Balance Sheet Account (b)Treasury stock (c)Common stock (d)Cash dividends payable (e)Accumulated depreciation (f)Interest payable (g)Deficit (h)Trading securities (i)Unearned revenue (a)Current asset/Investment (b)Stockholders Equity (c)Stockholders Equity (d)Current liability (e)Contra-asset (f)Current liability (g)Stockholders Equity (h)Current asset (i)Current liability Classification LO 2 Identify the major classifications of the balance sheet. Slide 43 43 Classified Balance Sheet Account form Report form Balance Sheet Format Accounting Trends and Techniques2009 (New York: AICPA) indicates that all of the 500 companies surveyed use either the report form (438) or the account form (62), sometimes collectively referred to as the customary form. LO 3 Prepare a classified balance sheet using the report and account formats. Slide 44 44 LO 3 Prepare a classified balance sheet using the report and account formats. Balance Sheet Format Account Form Illustration 5-16 Slide 45 45 LO 3 Balance Sheet Format Report Form Illustration 5-16 Slide 46 46 U. S. GAAP vs. IFRS Does not specify a minimum list of items to be presented in the balance sheet. Does not specify a minimum list of items to be presented in the balance sheet. Some U.S. companies use the statement of financial position title as well. Some U.S. companies use the statement of financial position title as well. Presents current assets and liabilities before noncurrent assets and liabilities. Presents current assets and liabilities before noncurrent assets and liabilities. There are more similarities than differences in balance sheets prepared according to U.S. GAAP and those prepared applying IFRS. Some difference are highlighted below. Specifies a minimum list of items to be presented in the balance sheet. Specifies a minimum list of items to be presented in the balance sheet. Statement title changed to statement of financial position. Statement title changed to statement of financial position. Does not prescribe the format of the balance sheet, but balance sheets prepared using IFRS often report noncurrent items first. Does not prescribe the format of the balance sheet, but balance sheets prepared using IFRS often report noncurrent items first. Slide 47 47 U. S. GAAP vs. IFRS The FASB and IASB are working together on the Financial Statement Presentation project to establish a common standard for presenting information in the financial statements. Each of the financial statements will include classifications by operating, investing, and financing activities, as well as income taxes, discontinued operations, and equity (if needed). Slide 48 48 Statement of Cash Flows LO 4 Indicate the purpose of the statement of cash flows. One of the three basic objectives of financial reporting is assessing the amounts, timing, and uncertainty of cash flows. Slide 49 49 To provide relevant information about the cash receipts and cash payments of an enterprise during a period. The statement provides answers to the following questions: 1.Where did the cash come from? 2.What was the cash used for? 3.What was the change in the cash balance? Purpose of the Statement of Cash Flows Statement of Cash Flows LO 4 Indicate the purpose of the statement of cash flows. Slide 50 50 Three different activities: Operating, Content and Format Statement of Cash Flows LO 5 Identify the content of the statement of cash flows. Investing, Financing Illustration 5-17 Basic Format of Cash Flow Statement Slide 51 51 Financing Cash inflows and outflows from non-current liabilities and equity. Statement of Cash Flows Operating Cash inflows and outflows that enter into the determination of net income. Investing Cash inflows and outflows from non-current assets. The statements value is that it helps users evaluate liquidity, solvency, and financial flexibility. LO 5 Identify the content of the statement of cash flows. Content and Format Slide 52 52 Statement of Cash Flows LO 5 Identify the content of the statement of cash flows. Illustration 5-18 Slide 53 53 Direct and Indirect Methods of Reporting Two Formats for Reporting Operating Activities Reports the cash effects of each operating activity Direct Method Starts with accrual net income and converts to cash basis Indirect Method Slide 54 54 Slide 55 55 Direct Method Under the direct method, the cash effect of each operating activity is reported directly in the statement. Slide 56 56 Indirect Method By the indirect method, we arrive at net cash flow from operating activities indirectly by starting with reported net income and working backwards to convert that amount to a cash basis. Slide 57 57 Information obtained from several sources: (1) comparative balance sheets, (2) the current income statement, and (3) selected transaction data. Sources of Information Preparation of the Statement of Cash Flows LO 6 Prepare a basic statement of cash flows. Slide 58 58 Statement of Cash Flows Statement of Cash Flows: On January 1, 2012, in its first year of operations, Telemarketing Inc. issued 50,000 shares of $1 par value common stock for $50,000 cash. The company rented its office space, furniture, and telecommunications equipment and performed marketing services throughout the first year. In June 2012 the company purchased land for $15,000. Illustration 5-19 shows the companys comparative balance sheets at the beginning and end of 2012. LO 6 Prepare a basic statement of cash flows. Slide 59 59 Statement of Cash Flows LO 6 Illustration 5-19 Illustration 5-20 Slide 60 60 Statement of Cash Flows Preparing the Statement of Cash Flows Determine: 1.Cash provided by (or used in) operating activities. 2.Cash provided by or used in investing and financing activities. 3.Determine the change (increase or decrease) in cash during the period. 4.Reconcile the change in cash with the beginning and the ending cash balances. LO 6 Prepare a basic statement of cash flows. Slide 61 61 Statement of Cash Flows Cash provided by operating activities Illustration 5-21 Illustration 5-19 Illustration 5-20 LO 6 Prepare a basic statement of cash flows. Slide 62 62 Statement of Cash Flows Illustration 5-21 Next, the company determines its investing and financing activities. Illustration 5-19 Illustration 5-20 Slide 63 63 Statement of Cash Flows Statement of Cash Flows (BE 5-12): Keyser Beverage Company reported the following items in the most recent year. Activity Operating Financing Operating Investing Operating Financing Required: Compute net cash provided by operating activities. Net income $40,000 Dividends paid 5,000 Increase in accounts receivable 10,000 Increase in accounts payable 7,000 Purchase of equipment 8,000 Depreciation expense 4,000 Issue of notes payable 20,000 LO 6 Prepare a basic statement of cash flows. Slide 64 64 Statement of Cash Flows Noncash charge to expenses. Statement of Cash Flows (BE 5-12) LO 6 Prepare a basic statement of cash flows. Noncash credit to revenues. Slide 65 65 Review In preparing a statement of cash flows, which of the following transactions would be considered an investing activity? a. Sale of equipment at book value b. Sale of merchandise on credit c. Declaration of a cash dividend d. Issuance of bonds payable at a discount receivable. Statement of Cash Flows LO 6 Prepare a basic statement of cash flows. Slide 66 66 Issuance of common stock to purchase assets. Conversion of bonds into common stock. Issuance of debt to purchase assets. Exchanges on long-lived assets. Statement of Cash Flows Significant financing and investing activities that do not affect cash are reported in either a separate schedule at the bottom of the statement of cash flows or in the notes. Examples include: Significant Noncash Activities LO 6 Prepare a basic statement of cash flows. Slide 67 67 Statement of Cash Flows Illustration 5-23 Comprehensive Statement of Cash Flows Slide 68 68 Like U.S. GAAP, international standards also require a statement of cash flows. Consistent with U.S. GAAP, cash flows are classified as operating, investing, or financing. U. S. GAAP vs. IFRS Operating Activities Operating Activities Dividends Received Dividends Received Interest Received Interest Received Interest Paid Interest Paid Investing Activities Investing Activities Financing Activities Financing Activities Dividends Paid Dividends Paid Operating Activities Operating Activities Investing Activities Investing Activities Dividends Received Dividends Received Interest Received Interest Received Financing Activities Financing Activities Dividends Paid Dividends Paid Interest Paid Interest Paid Typical Classification of Cash Flows from Interest and Dividends Slide 69 69 U. S. GAAP vs. IFRS The FASB and IASB are working together on a project, Financial Statement Presentation, to establish a common standard for presenting information in the financial statements. Slide 70 70 High amount - company able to generate sufficient cash to pay its bills. Low amount - company may have to borrow or issue equity securities to pay bills. Usefulness of the Statement of Cash Flows Without cash, a company will not survive. Cash flow from Operations: LO 7 Understand the usefulness of the statement of cash flows. Slide 71 71 Usefulness of the Statement of Cash Flows Ratio indicates whether the company can pay off its current liabilities from its operations. A ratio near 1:1 is good. LO 7 Understand the usefulness of the statement of cash flows. Financial Liquidity Net Cash Provided by Operating Activities Average Current Liabilities Current Cash Debt Coverage Ratio = Slide 72 72 Usefulness of the Statement of Cash Flows This ratio indicates a companys ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations. LO 7 Understand the usefulness of the statement of cash flows. Net Cash Provided by Operating Activities Average Total Liabilities Cash Debt Coverage Ratio = Financial Liquidity Slide 73 73 Usefulness of the Statement of Cash Flows The amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity. LO 7 Understand the usefulness of the statement of cash flows. Illustration 5-28 Free Cash Flow Slide 74 74 Review The current cash debt coverage ratio is often used to assess a. financial flexibility. b. liquidity. c. profitability. d. solvency. LO 7 Understand the usefulness of the statement of cash flows. Usefulness of the Statement of Cash Flows Slide 75 75 Supplemental Disclosures Four types of information that are supplemental to account titles and amounts presented in the balance sheet: LO 8 Determine which balance sheet information requires supplemental disclosure. Slide 76 76 Parenthetical Explanations Notes Cross-Reference and Contra Items Supporting Schedules Terminology Techniques of Disclosure LO 9 Describe the major disclosure techniques for the balance sheet. Slide 77 77 RELEVANT FACTS IFRS recommends but does not require the use of the title statement of financial position rather than balance sheet. IFRS requires a classified statement of financial position except in very limited situations. IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities. However under GAAP, public companies must follow SEC regulations, which require specific line items. In addition, specific GAAP standards mandate certain forms of reporting this information. Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last. Slide 78 78 RELEVANT FACTS IFRS has many differences in terminology that you will notice in this textbook. Both IFRS and GAAP require disclosures about (1) accounting policies followed, (2) judgments that management has made in the process of applying the entitys accounting policies, and (3) the key assumptions and estimation uncertainty that could result in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. Comparative prior period information must be presented and financial statements must be prepared annually. Use of the term reserve is discouraged in GAAP, but there is no such prohibition in IFRS. Slide 79 79 End of Lecture 07