Chapter 2 - Concept Questions

What are the two essential characteristics of an asset?

An asset must be "owned" or "controlled," it must provide "future economic benefits," and it must arise from a past transaction or event. Owning means having title to the asset (some leased assets are also recorded on the balance sheet because they are controlled, as we will discuss in our Module 10 entitled, "Reporting and Analyzing Off-Balance-Sheet Financing"). Future benefits may mean the future inflows of cash, or an increase in another asset, or reduction of a liability. Past event means the company has purchased the asset or acquired it in some other cash or noncash transaction or event.

The balance sheet consists of assets, liabilities, and equity. Define each category, and provide two examples of accounts reported within each category.

An asset represents resources a company owns or controls. Assets are expected to provide future economic benefits. Assets arise from past events or transactions. A liability is an obligation that will require a future economic sacrifice. Equity is the difference between assets and liabilities. It represents the claims of the company's owners to its income and assets.

Identify three intangible assets that are recorded on the balance sheet.

An intangible asset is an asset that is not physical in nature. To be included on the balance sheet, it has to meet two tests: the company must own or control the asset, it must provide future economic benefits, and the asset must arise from a past event or transaction. Some examples are goodwill, patents and trademarks, contractual agreements like royalties, leases, and franchise agreements. An intangible asset is only recorded on the balance sheet when it is purchased from an outside party. For example, goodwill arises when the company acquires (either with cash or stock) another company's brand name or any of the other intangibles listed above.

Describe the linkage between the income statement and the equity section of the balance sheet. Describe the linkage between the statement of cash flows and the equity section of the balance sheet when a company pays dividends.

The income statement and the equity section on the balance sheet are linked via retained earnings. When a company reports net income, the amount increases retained earnings. Similarly, losses on the income statement decrease retained earnings on the balance sheet. When a company pays a dividend, retained earnings decrease. The amount of the dividend paid is reported on the statement of cash flows as a use of funds (outflow) in the financing section.

Assets are recorded at historical costs even though current market values might, arguably, be more relevant to financial statement readers. Describe the reasoning behind historical cost usage.

GAAP uses historical costs because they are less subjective than market values. Market values can be biased for two reasons: first, we may not be able to measure them accurately (consider our inability to accurately measure the market value of a manufacturing facility, for example), and second, managers may intervene in the reporting process to intentionally bias the results to achieve a particular objective (like enhancing the stock price).

Identify three intangible assets that are likely to be excluded from the balance sheet because they cannot be reliably measured.

Generally, excluded intangible (unrecorded) assets are those that contribute to a company's sustainable competitive advantage, but that cannot be measured accurately. Some examples include the value of a brand, the management of a company, employee morale, a strong supply chain, superior store locations, credibility with the financial markets, reputation, and so forth.

Define and explain the concept of financial statement articulation. What insight comes from understanding articulation?

Articulation refers to the fact that the four financial statements are linked to each other and that changes in one statement affect the other three. For example, net income reported on the income statement is linked to the statement of retained earnings, which in turn is linked to the balance sheet. Understanding how the financial statements articulate helps us to analyze transactions and events and to understand how events affect each financial statement separately and all four together.

What is the difference between company book value and market value? Explain why these two amounts differ.

Book value is the amount at which an asset (or liability) is carried on the balance sheet. The book value of the company is the book value of all the assets less the book value of all the liabilities, that is, the book value of stockholders' equity. Book values are determined in accordance with GAAP. Market value is the sale price of an asset or liability. Markets are not constrained by GAAP standards and, therefore, can consider a number of factors that accountants cannot. Market values, therefore, generally differ significantly from book values.

What does the term current denote when referring to assets?

Current means that the asset will be liquidated (converted to cash) or used in operations within the next year (or the operating cycle if longer than one year).

Explain how we account for a cost that creates an immediate benefit versus a cost that creates a future benefit.

A cost that creates an immediate benefit is reported on the income statement as an expense. A cost that creates a future benefit is added to the balance sheet as an asset (capitalized) and will be transferred to the income statement as the benefit is realized. For example, PPE creates a future benefit and the cost of the PPE is transferred to the income statement (as depreciation expense) over the life of the PPE.

GAAP is based on the concept of accrual accounting. Define and describe accrual accounting.

Accrual accounting means that we record revenues when earned, and record expenses when they are incurred. Accrual accounting does not rely on cash flows in determining when items are revenues or expenses. This is why net income (a GAAP measure) differs from cash from operations.

What are accrued liabilities? Provide an example.

An accrued liability is an obligation for expenses that have been incurred but not yet paid for with cash. Examples include wages that have been earned by employees and not yet paid, interest owing on a bank loan, and potential future warranty claims for products sold to customers. When the liability is recognized on the balance sheet, a corresponding expense is recognized in the income statement.

Describe the flow of costs for the purchase of a machine. At what point do such costs become expenses? Why is it necessary to record the expenses related to the machine in the same period as the revenues it produces?

When a company purchases a machine it records the cost as an asset because it will provide future benefits. As the machine is used up, a portion of this cost is transferred from the balance sheet to the income statement as depreciation expense. The machine asset is, thus, reduced by the depreciation, and equity is reduced as the expense reduces net income and retained earnings. If the entire cost of the machine was immediately expensed, profit would be reduced considerably in the year the machine was purchased. Then, in subsequent years, net income would be far too high as none of the machine's cost would be reported in those years even though the machine produced revenues during that period.

What does the concept of liquidity refer to? Explain.

Liquidity refers to the ready availability of cash. That is, how much cash the company has on hand, how much cash is being generated, and how much cash can be raised quickly. Liquidity is essential to the survival of the business. After all, firms must pay loans and employee wages with cash.

Define net working capital. Explain how increasing the amount of trade credit can reduce the net working capital for a company.

Net working capital = Current assets - Current liabilities. Increasing the amount of trade credit (e.g., accounts payable to suppliers) increases current liabilities and reduces net working capital. Trade credit is like borrowing from a supplier to make purchases. As trade credit increases, the supplier is lending more money than before. This frees up cash, which the company can use for other purposes such as paying down interest-bearing debt or purchasing additional productive assets. Thus, net working capital decreases. This can be a good thing. As a business grows, its net working capital grows because inventories and receivables generally grow faster than accounts payable and accrued liabilities do. Net working capital must be financed just like long-term assets.

What is the statement of cash flows? What useful information does it contain?

The statement of cash flows reports the company's cash inflows and outflows during the period, and categorizes them according to operating, investing and financing activities. The income statement reports profit earned under accrual accounting, but does not provide sufficient information concerning cash flows. The statement of cash flows fills that void.

What is the statement of stockholders' equity? What useful information does it contain?

The statement of stockholders' equity provides information about the events that impact stockholders' equity during the period. It contains information relating to net income, stock sales and repurchases, option exercises, dividends and other accumulated comprehensive income.

Analysts attempt to identify transitory items in an income statement. Define transitory items. What is the purpose of identifying transitory items?

Transitory items are revenues and expenses that are not expected to recur. One objective of financial analysis is to predict future performance. Given that perspective, transitory (nonrecurring) items are not relevant except to the extent that they convey information about future financial performance.