The Balance Sheet and Notes to Financial Statements

Intermediate Accounting,17E

Stice | Stice | Skousen

PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University© 2010 Cengage Learning

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The Balance Sheet

• A balance sheet presents a listing of an organization’s assets and liabilities at a certain point in time.

• The difference between assets and liabilities is called equity.

• The balance sheet is designed using the basic accounting equation:Assets = Liabilities + Owners’ Equity

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Accounting is not a science.

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The primary purpose of the balance sheet is to help forecast the future.

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If a company economically controls the future economic benefits association with an item, that item qualifies as an asset whether it is legally owned or not.

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This term includes legal commitments as well as moral, social, and implied obligations.

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Most liabilities involve an obligation to transfer assets in the future. However, an obligation to provide a service is also a liability.

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Assets and liabilities arise from transactions or events that have already happened.

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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• Receivables• Inventories

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The normal operating cycle involves the use of cash to purchase inventories, the sale of inventories resulting in receivables, and ultimately the cash collection of those receivables.

Current Assets

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• In addition to cash, receivables, and inventories, current assets typically include prepaid expenses and investments in certain securities.

• Debt and equity securities that are purchased mainly with the intent of reselling these securities in the short term are called trading securities.

Current Assets

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• Current assets are normally listed on the balance sheet before the noncurrent assets and in the order of their liquidity, with the most liquid items first.

Current Assets

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Noncurrent Assets

• Investments • Property, plant, and

equipment• Intangible assets• Deferred income taxes

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Investments

Investments held for such long-term purposes as regular income, appreciation, or ownership control are reported under the heading Investments.

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Property, plant, and equipment are properties of a tangible and relatively permanent nature that are used in the normal business operations.

Plant, Property, and Equipment

• Land• Buildings• Machinery• Tools

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Intangible assets are long-term rights and privileges of a nonphysical nature acquired for use in business operations.

Intangible Assets

• Goodwill• Patents• Trademarks• Franchises

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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

Current Liabilities

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Sinking FundSinking Fund

A sinking fund is comprised of cash and investment securities that have been accumulated for the stated purpose of repaying a specific loan.

Current Liabilities

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Short-Term ObligationsShort-Term Obligations

If a short-term loan is expected to be refinanced or paid back with the proceeds of a replacement loan, the existing short-term loan will not require the use of current assets even though it is scheduled to mature within a year.

Current Liabilities

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The existing loan is not classified as current as long as:1. The intent of the company is to

refinance the loan on a long-term basis.2. The company’s intent is evidenced by

an actual refinancing after the balance sheet date but before the financial statements are finalized or by the existence of an explicit refinancing agreement.

Current Liabilities

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A callable obligation is one that is payable on demand and thus has no specified due date. If an agreement calls for an obligation to be due on demand or to become due on demand within one year from the balance sheet date, the obligation should be classified as current.

Callable Obligations

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Noncurrent Liabilities

Current liabilities do not usually include:• Debts to be liquidated from a

noncurrent sinking fund.• Short-term obligations to be

refinanced.

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•Long-term debt•Long-term lease obligations•Deferred income tax

liability•Pension obligations

Obligations not reasonably expected to be paid or otherwise satisfied within 12 months are classified as noncurrent liabilities.

Noncurrent Liabilities

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• 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 a long-term liability.

• Most large companies include deferred income tax liabilities on the balance sheet.

Noncurrent Liabilities

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Contingent Liabilities

• Past activities or circumstances may give rise to possible future liabilities, although obligations do not exist on the balance sheet date. These potential claims that involve uncertainty as to possible losses are known as contingent liabilities

• An estimated liability is a definite obligation with only the amount in question and subject to estimation on the balance sheet date.

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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

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Contributed Capital

Two parts of contributed capital:1. Capital stock—the number of shares the par

valuea. Preferred stock—usually pays a fixed annual

cash dividend and provides rights to recover investment in case of bankruptcy

b. Common stock—provides real ownership of the corporation and grants voting power, but holders are last in line for assets in case of bankruptcy

2. Additional paid-in capital—investment by shareholders in excess of par value of capital stock

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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, retained earnings is restricted and unavailable for cash dividends.

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Treasury Stock

• When a company buys back its own shares, accountants call the repurchased shares treasury stock.

• Treasury shares can be retired, or they can be retained and reissued later.

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Available-for-Sale Securities

•Available-for-sale securities are those that were not purchased with the immediate intention to resell, but are not meant to be held permanently.

•These securities are reported in the balance sheet at their current market value.

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Foreign Currency Transaction Adjustments

Foreign currency transaction adjustments arise from the change in the equity of foreign subsidiaries that occurs during the year as a result of changes in foreign currency exchange rates.

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Unrealized Gains and Losses on Derivatives

A derivative is a financial instrument, such as an option or a future, that derives its value from the movement of a price, an exchange rate, or an interest rate associated with some other item.

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Minority Interest

In the consolidated balance sheet, minority interest is the amount of equity investment made by outside shareholders to consolidated subsidiaries that are not 100% owned by the parent company.

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International Reserves

International reserves are merely different equity categories similar in nature, depending on the reserve, to additional paid-in capital or to restricted retained earnings.

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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.

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Format of ForeignBalance Sheets

Foreign balance sheets are frequently presented with property, plant, and equipment and intangibles listed first. They frequently list the current assets and current liabilities together and label the difference between the two as net current assets or net working capital.

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Liquidity

Liquidity is the ability of a firm to satisfy its short-term obligations.A common indicator of the overall liquidity of a company is the current ratio.

Current ratio = Current assetsCurrent liabilities

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Liquidity

The WITH CLASSIFICATION section of Exhibit 3-8 will serve as the source of information for all ratios in Slides 3-45 through 3-53.

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Current assets

Current liabilities

Current Ratio

$812,600

$499,500

= 1.63

Historically, the Historically, the rule of thumb is rule of thumb is that a current ratio that a current ratio below 2.0 below 2.0 suggests liquidity suggests liquidity problems.problems.

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Liquidity

Another ratio used to measure a firm’s liquidity is the quick ratio, also known as the acid-test ratio. It indicates how well a firm can satisfy existing short-term obligations with assets that can be converted into cash without difficulty.

Quick ratio =Cash + Securities +

ReceivablesCurrent liabilities

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(Cash + Sec. + Rec.)

Current liabilities

$483,700

$499,500

= 0.97

Quick Ratio

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Overall Leverage

Comparing the amount of liabilities to the amount of assets held by a business indicates the extent to which borrowed funds have been used to leverage the owners’ investments and increase the size of the firm.

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Total liabilities

Total assets

$1,098,700

$1,952,600

= 0.56

Techtronics Techtronics borrowed 50% of borrowed 50% of the money it the money it needed to buy its needed to buy its assets.assets.

Debt Ratio

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Relationships Between Balance Sheet and Income Statement Amounts

EfficiencyEfficiency

A financial ratio that gives an overall measure of company efficiency is called asset turnover. Assuming sales of $4,000,000, the turnover is:

Techtronics generates $2.05 in Techtronics generates $2.05 in sales for each dollar of assets. sales for each dollar of assets.

= 2.05 SalesTotal assets =

$4,000,000

$1,952,600

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Overall ProfitabilityOverall Profitability

To appropriately measure profitability, net income must be compared to some measure of the size of the investment. Two financial ratios used to assess a firm’s overall profitability are return on assets and return on equity.

Relationships Between Balance Sheet and Income Statement Amounts

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Return on AssetsReturn on Assets

Net incomeTotal assets

= $150,000$1,952,600

= 7.7%

This means that one dollar of Techronics’ assets generated 7.7 cents in net income.

Relationships Between Balance Sheet and Income Statement Amounts

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Return on EquityReturn on Equity

Net incomeStockholders’

equity

=$150,000

$853,900= 17.6%

Techronics’ stockholders earned 17.6 cents per each dollar of equity invested.

Relationships Between Balance Sheet and Income Statement Amounts

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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

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Subsequent Events

• The SEC requires large publicly traded companies to file financial statements within 60 days of fiscal year-end.

• Business continues during this “subsequent period” and events could have an impact upon the firm’s financial statements.

• These events are referred to in the accounting literature as subsequent events or post-balance sheet events.

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Limitations of the Balance Sheet

• Balance sheets do not generally reflect the current value of a business.

• A favorite ratio among followers of the stock market is the book-to-market ratio, which reflects the difference between the balance sheet value of a company and the company’s actual market value.