Accounting chapter 6
What are three limitations associated with the balance sheet?
1. Many balance sheet accounts are reported at historical cost instead of market values or liquidation values; this limits the relevance of information in the balance sheet. 2. A number of assets and liabilities, such as human capital and reputation, are not reported on the balance sheet. 3. Many balance sheet accounts are based upon estimates as opposed to determinable amounts.
List three areas in which the balance sheet provides important information to financial statement users.
1. The balance sheet summarizes economic resources and obligations that impact the entity's ability to generate future cash flows. 2. The balance sheet is useful in assessing an entity's rate of return on its investments. 3. The balance sheet aids in assessing the risk associated with an entity by providing inputs for cash flow measures.
List and describe the two balance sheet formats.
The two formats are the account and report formats. The account format lists assets on the left side and liabilities and stockholders' equity on the right side of the statement. The report format lists liabilities and stockholders' equity directly below assets on the same page.
Compare and contrast the presentation of assets under U.S. GAAP versus IFRS reporting.
Under U.S. GAAP, after grouping assets as current and noncurrent, further classifications within those categories are made when compiling a balance sheet. Specifically, within current and noncurrent assets, companies list each asset in decreasing order of liquidity. Current assets precede noncurrent assets. The most liquid asset is first, followed by less liquid assets. Cash, the most liquid asset, is usually listed first, followed by short-term investments, receivables, and then other less liquid assets. With IFRS-reporting, companies can present either current assets or noncurrent assets first. IFRS permits asset presentation in either a decreasing or an increasing order of liquidity. When using an increasing order of liquidity, the least-liquid assets are typically presented first within each balance sheet section.
A subsequent event is a significant event that occurs after the date of the fiscal year-end, but before the financial statements are issued or available to be issued. Explain how these significant events are disclosed.
An entity can recognize material subsequent events either in the financial statements for the preceding year or disclose them in the notes to the financial statements. The recognition versus disclosure decision depends upon whether the event relates to a condition that existed on the balance sheet date (the end of the fiscal year). If the condition existed as of the balance sheet date, the firm should make an adjustment to the financial statements to account for the subsequent event. If the condition did not exist as of the balance sheet date, the entity is only required to disclose the subsequent event, as opposed to adjusting the financial statements.
After grouping assets as current and noncurrent what further classifications within those categories are made when compiling a balance sheet? ASSUME U.S. GAAP.
Companies make further classifications. Specifically, within current and noncurrent assets, companies list each asset in decreasing order of liquidity. Current assets precede noncurrent assets. The most liquid asset is first, followed by less liquid assets. In the current assets section, cash, the most liquid asset, is usually listed first, followed by short-term investments, receivables, merchandise inventories, and then prepaid expenses. In the noncurrent assets, long-term investments are listed, followed by property, plant and equipment, intangible assets and other assets. Within property, plant, and equipment, land is listed first, followed by buildings, equipment, furniture, and fixtures.
Define the Dupont Analysis model and explain the relationship between its components.
Dupont Analysis separates return on equity (ROE) into two components to analyze a company's sources of profitability. Return on equity is defined as (Net Income / Average Stockholders' Equity). ROE can be expanded into two components: Return on Assets (ROA) and Financial Leverage. ROA is defined as (Net Income / Average Total Assets) while financial leverage is defined as (Average Total Assets / Average Stockholders' Equity). The lower the financial leverage ratio, the lower the amount of debt financing that is being used. When ROA is constant, a company can increase its ROE by increasing financial leverage. However, it must balance this with the risk of insolvency from too much debt.
Explain the importance of the summary of significant accounting policies and list five facts that are generally included in this note.
The Summary of Significant Accounting Policies is the first footnote discusses a company's GAAP-based methods in preparing financial statements. Five facts that are included in this footnote are: 1. Method of revenue recognition 2. Method of valuing inventories 3. Definition of cash and cash equivalents 4. Methods of accounting for income tax 5. Methods of depreciation used for depreciation property, plant, and equipment
Explain the difference between the direct and indirect methods of preparing the operating section of the statement of cash flows. Which method is preferred by GAAP?
When the INDIRECT method of preparing the operating section of the statement of cash flows is used, net income is the starting point. Non-cash expenses such as depreciation expense and non-operating items, (such as losses on sales of assets are added back to net income), because they do not result in an outflow of cash. Likewise, non-operating revenue items, (such as gains on sale of equipment and investments are deducted from net income), because they do not create inflows of cash. After these adjustments are made, then changes in elements of working capital are added or subtracted. Decreases in current assets and increases in current liabilities are added to net income, while increases in current assets and decreases in current liabilities are subtracted from net income. The end result is net cash provided/used by operating activities. The DIRECT method of preparing the operating activities section of the statement of cash flows converts each element of income and expense on the income statement from the accrual basis to the cash basis of accounting. Sales revenue is adjusted by adding the decrease in accounts receivable (or subtracting the increase in accounts receivable) to arrive at cash received from customers. Likewise, cost of goods sold is converted into cash paid for merchandise by adding the increase in inventory (or subtracting the decrease in inventory) and subtracting the increase in accounts payable (or adding the decrease in accounts payable). Other expenses are adjusted in a similar fashion and depreciation and amortization are omitted. Because the direct method of presenting cash flows from operating activities is more easily understandable, GAAP prefers its use on the statement of cash flows. However, most companies choose to use the indirect method.
Explain the additional footnote disclosures to financial statements that are required by IFRS.
While IFRS requires similar information to GAAP with regard to significant accounting policies, subsequent events, and related part transactions, IFRS has additional requirements with regard to subsequent events, related part transactions, and sources of estimation uncertainty for assets and liabilities. • Subsequent events—Under IFRS, if a company's board of directors has authorized the issuance of the financial statements before a subsequent event occurs, it does not have to be reported on the financial statements. • Related party transactions—In addition to the disclosures required under GAAP, IFRS also requires specific disclosures on executive compensation in total and by type. • Sources of estimation uncertainty—Under IFRS, companies are required to disclose information about the assumptions and estimated made at the end of the reporting period and if there will be a significant risk of material adjustment in the subsequent period.
List and explain three common cash flow measures based upon balance sheet information.
1. Liquidity is a measure of an asset's ability to be quickly converted to cash without risk of loss. 2. Solvency is a measure of a firm's long-term ability to pay its obligations as they mature. 3. Financial flexibility indicates an entity's ability to respond to unexpected needs and opportunities by taking actions that alter the amounts and timing of cash flows.
List the types of opinions that may be issued by an auditor on a company's financial statements and explain the circumstances under which it is issued.
1. Unqualified—This is also known as a "clean" opinion. This opinion asserts that the financial statements have been fairly presented in accordance with generally accepted accounting principles. 2. Unqualified Opinion with Explanatory Paragraph—This type opinion is issued with there is a lack of consistency, a going concern issue, or a particular matter that should be emphasized. The statements are fairly presented but an explanatory paragraph is needed to clarify a point. 3. Qualified—The auditor concludes that: (1) the financial statements are fairly presented, but the scope of the audit was subject to significant limitations or (2) the financial statements are not in compliance with GAAP. 4. Adverse—There is a major departure from GAAP, such as expensing all capital expenditures, that causes the financial statements to not be fairly presented in accordance with generally accepted accounting principles. 5. Disclaimer of Opinion—Because the auditor is unable to form an opinion or a lack of independence on the part of the auditor, it is not possible to issue an opinion on the fair presentation of the financial statements. This is not the same thing as withdrawing from the engagement.
Define the term subsequent event, explain the two types of subsequent events and provide an example of each.
A subsequent event is one that occurs in the time frame after the ending date of a company's fiscal year but before the financial statements are issued. There are two types of significant events: 1. Those with circumstances that existed at the date of the balance sheet and 2. Those with circumstances that did not exist at the balance sheet date. An example of the first type of event is a customer whose account was significantly delinquent as of the balance sheet date and who subsequently became insolvent and filed for bankruptcy. Such an event requires both a financial statement adjustment and disclosure. The second type of event is one that did not exist at the balance sheet date. It must be disclosed, but it does not require financial statement adjustment. An example of such an event is a stock split that occurred between the end of the year and the issuance of the financial statements. This will have a significant effect on subsequent financial statements but it does not affect the current one.
Describe the statement of cash flows and its purpose including what a financial statement user can determine or assess by reviewing a well-prepared statement of cash flows.
The statement of cash flows provides information about a firm's cash receipts and cash payments during a period of time. The statement reconciles the change in the cash balance to the cash flows for the period and summarizes the firm's cash flows by classifying them into operating, investing, and financing activities. The statement of cash flows enables financial statements users to: 1. Assess the entity's ability to meet its obligations and pay dividends. 2. Determine whether the entity will require external financing. 3. Identify the differences between net income and the associated cash receipts and payments.