Ch. 2 The Balance Sheet

Accounts payable

- Accounts payable are short-term obligations that arise from credit extended by suppliers for the purchase of goods and services. - The ongoing process of operating a business results in the spontaneous generation of accounts payable, which increase and decrease depending on the credit policies available to the firm from its suppliers, economic conditions, and the cyclical nature of the firm's own business operations.

Goodwill

- Goodwill arises when one company acquires another company (in a business combination accounted for as a purchase) for a price in excess of the fair market value of the net identifiable assets (identifiable assets less liabilities assumed) acquired. - If impairment charges are related to goodwill, it is important to read the footnote disclosures to determine why goodwill was impaired.

Long-term notes payable

Contractual agreement between borrower and lender (generally a bank) which designates the principal and interest repayment schedule and other conditions of the loan.

Mortgage

Loan agreement secured by real estate.

Long-term Debt

Obligations with maturities beyond one year are designated on the balance sheet as con-current liabilities.

Debentures

Unsecured debt backed by the company's general credit standing

Accounts Receivable

- Accounts receivable are customer balance outstanding on credit sales and are reported on the balance sheet at their net realizable value, that is, the actual amount of the account less an allowance for doubtful accounts. - Actual losses are written off against the allowance account, which is adjusted at the end of each accounting period. - The analyst should be alert to changes in the allowance account--both relative to the level of sales and the amount of accounts receivable outstanding--and to the justification for any variations from past practices. - The allowance account, which is deducted from the balance sheet accounts receivable account, should reflect the volume of credit sales, the firm's past experience with customers, the customer base, the firm's credit policies, the firm's collection practices, economic conditions, and changes in any of these. - Additional information helpful to the analysis of accounts receivable and the allowance account is provided in the schedule of "Valuation and Qualifying Accounts" required by the SEC in the Form 10-K.

Accrued Liabilities

- Accrued liabilities result from the recognition of an expense in the accounting records prior to the actual payment of cash. - Reserve accounts are often set up for the purpose of estimating obligations for items such as warranty costs, sales returns, or restructuring charges, and are recorded as accrued liabilities. - Reserve accounts are also set up to record declines in asset values.

Introduction

- Balance sheet: also called the statement of condition or statement of financial position; provides a wealth f valuable information about a business firm, particularly when examined over a period of several years and evaluated in relation to the other financial statements. - Inventory is an important component of liquidity analysis, which considers the ability of a firm to meet cash needs as they rise.

Commitments and Contingencies

- Commitments refer to contractual agreements that will have a significant financial impact on the company in the future. - Operating leases are a form of off-balance sheet financing. - In fact, the lessee is contractually obligated to make lease payments but is not required by generally accepted accounting principles (GAAP) to record this obligation as a debt on the balance sheet. - Disclosures about the extent, nature, and terms of off-balance sheet financing arrangements are in the notes to the financial statements, but they may be very complex and difficult to understand, and require putting pieces together from several different sections. - Contingencies refer to potential liabilities of the firm such as possible damage awards assessed in lawsuits. - Generally, the firm cannot reasonably predict the outcome and/or the amount of the future liability; however, information about the contingency must be disclosed in the notes to the financial statements.

Common-Size Balance Sheet

- Common-size financial statements are a form of vertical ratio analysis that allows for comparison of firms with different levels of sales or total assets by introducing a common denominator. - Common-size statements are also useful to evaluate trends within a firm and to make industry comparisons. - A common-size balance sheet expresses each item on the balance sheet as a percentage of total assets. - The common-size balance sheet reveals the composition of assets within major categories, for example, cash and cash equivalents relative to other current assets, the distribution of assets in which funds are invested (current, long-lived, intangible), the capital structure of the firm (debt relative to equity), and the debt structure (long-term relative to short-term).

Current Assets

- Current assets include cash or those assets expected to be converted into cash within one year or one operating cycle, whichever is longer. - The operating cycle is the time required to purchase or manufacture inventory, sell the product, and collect the cash. - The term working capital or net working capital is used to designate the amount by which current assets exceed current liabilities (current assets less current liabilities).

Convertible debt

- Debt in the form of bonds or notes that allows the investor or lender the opportunity to exchange a company's debt for common stock of that company.

Deferred Federal Income Taxes

- Deferred taxes are the result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income. - They are called temporary differences (or timing differences) because, in theory, the total amount of expense and revenue recognized will eventually be the same for tax and reporting purposes. - The deferred tax account reconciles the temporary differences in expense and revenue recognition for any accounting period. - Business firms recognize deferred tax liabilities for all temporary differences when the item causes financial income to exceed taxable income with an expectation that the difference will be offset in future accounting period. - A valuation allowance is used to reduce deferred tax assets to expected realizable amounts when it is determined that it is more likely than not that some of the deferred tax assets will not be realized. - Deferred taxes are classified as current or non-current on the balance sheet, corresponding to the classification of related assets and liabilities underlying the temporary difference.

Common Stock

- Dividends on common stock are declared at the discretion of a company's board of directors. - Further, common shareholders can benefit from stock ownership through potential price appreciations (or the reverse can occur if the share price declines).

Bonds payable

- Financial instruments used to raise cash which are traded in capital markets. - Bonds are generally issued in denominations of $1,000 (face value or maturity value) and have a stated interest rate. - Since bonds are traded on markets, the issue price investors are willing to pay more be more or less than the face or maturity value.

Comparative Data

- Financial statements for only one accounting period would be of limited value because there would be no reference point for determining changes in a company's financial record over time. - As part of an integrated disclosure system required by the SEC, the information presented in annual reports to shareholders includes two-year audited balance sheets and three-year audited statements of income and cash flows.

Prepaid Expenses

- General expenses, such as insurance, rent, property taxes, and utilities, are sometimes paid in advance. - They are included in current assets if they will expire within one year or one operating cycle, whichever is longer.

Capital Lease Obligations

- If a lease contract meets ant one of four criteria--transfers ownership to the lessee, contains a bargain purchase option, has a less term of 75% or more of the leased property's economic life, or has minimum lease payments with a present value of 90% or more of the property's fair value--the lease must be capitalized by the lessee according to the requirements of FASB. - An asset and a liability are recorded on the lessee's balance sheet equal to the present value of the lease payments to be made under the contract. - The asset account is amortized with amortization expense recognized on the income statement, just as a purchased asset would be depreciated. - Disclosures about capital leases can be found in the notes to the financial statements, often under both the property, plant, and equipment note and the commitments and contingencies note.

Quality of Financial Reporting--The Balance Sheet

- In general, a firm should strive for a matching of debt to the type of asset being financed; that is, short term debt should be used to finance current assets, and long-term debt (or equity) should be used to finance long-term assets.

Inventories

- Inventories are items held for sale or used in the manufacture of products that will be sold. - A manufacturing firm, in contrast, would carry three different types of inventories: raw materials or supplies, work-in-process, and finished goods. - Given the relative magnitude of inventory, the accounting method chosen to value inventory and the associated measurement of cost of goods sold have a considerable impact on a company's financial position and operating results.

Current Liabilities

- Liabilities represent claims against assets, and current liabilities are those that must be satisfied in one year or one operating cycle, whichever is longer. - Current liabilities include accounts and notes payable, the current portion of long-term debt, accrued liabilities, unearned revenue, and deferred taxes.

Marketable Securities

- Marketable securities, also referred to as short-term investments, are highly liquid investments in debt and equity securities that can be readily converted into cash to mature in a year or less. - Firms with excess cash that is not needed immediately in a business will often purchase marketable securities to earn a return. - The valuation of marketable securities on the balance sheet as well as other investments in debt and equity securities requires the separation of investment securities into 3 categories depending on the intent of the investment: 1. Held to maturity applies to those debt securities that the firm has the positive intent and ability to hold to maturity; these securities are reported at amortized cost. 2. Trading securities are debt and equity securities that are held for resale in the short term, as opposed to being held to realize longer-term gains from capital appreciation. - These securities are reported at fair value with unrealized gains and losses included in earnings. 3. Securities available for sale are debt and equity securities that are not classified as one of the other two categories, either held to maturity or trading securities. - Securities available for sale are reported at fair value with unrealized gains and losses included in comprehensive income.

Long-term warranties

- Non-monetary liabilities that promise the delivery of goods or services during a specified warranty period. - Examples would include a two-year warranty offered for new home construction or three-year warranty offered for new car purchases.

Other Assets

- Other assets on a firm's balance sheet can include a multitude of other concurrent items such as property held for sale, start-up costs in connection with a new business, the cash surrender value of life insurance policies, and long-term advance payments. - Additional categories of concurrent assets frequently encountered are long-term investments and intangible assets (other than goodwill), such as patents, copyrights, trademarks, brandnames, and franchises.

Stockholders' Equity

- Ownership equity is the residual interest in assets that remains after deducting liabilities. - The owners bear the greatest risk because their claims are subordinate to creditors in the event of liquidation, but owners also benefit from the rewards of a successful enterprise.

Pensions and Post-retirement Benefits

- Pensions are cash compensation paid to retired employees. - A firm into the employees' pension fund an amount that will hopefully cover the ultimate benefits that will be paid to employees in the future. - The amount paid into the fund plus the earnings on the fund's assets may bel less than the estimated pension obligation. - In this case, a net pension liability would be included in the liability section of the balance sheet.

Short-Term Debt

- Short-term debt (also referred to as notes payable) consists of obligations in the form of promissory notes to suppliers or financial institutions due in one year or less. - Commercial paper is unsecured, short-term notes issued by a corporation to meet short-term financing needs. - Maturities are generally less than 270 days and are often issued at discounted interest rates since only firms with high credit ratings can find buyers from this form of debt.

Balance Sheet Format

- The FASB, SEC, and IASB do not prescribe the format of the balance sheet. - This means that the asset and liability sections are categorized into key sections. - Asset classifications generally include a section for current assets, property, plant and equipment, intangible assets and other assets, while liability classifications include current liabilities and concurrent liabilities. - In the US, accounts are usually listed in terms of liquidity within sections. - The most liquid assets are listed first; liabilities are listed in order of maturity.

Additional Paid-In Capital

- The additional paid-in capital account is not affected by the price changes resulting from stock trading subsequent to its original issue.

Financial Condition

- The balance sheet shows the financial condition or financial position of a company on a particular date. - The statement is a summary of what the firm owns (assets) and what the firm owes to outsiders (liabilities) and to internal owners (stockholders' equity). - By definition, the account balances on a balance sheet must balance; that is, the total of all assets must equal the sum of liabilities and stockholders' equity. Assets = Liabilities + Stockholders' equity

Unearned Revenue or Deferred Credits

- The liability account is referred to as unearned revenue or deferred credits. - The amounts in this account will be transferred to a revenue account when the service is performed or the product delivered as required by the matching concept of accounting.

Inventory Accounting Methods

- The method chosen by a company to account for inventory determines the value of inventory on the balance sheet and the amount of expense recognized for cost of goods sold on the income statement. - The significance of inventory accounting is underlined by the presence of inflation and by the implications for tax payments and cash flow. - Inventory valuation is based on an assumption regarding the flow of goods and has nothing whatever to do with the actual order in which products are sold. - The cost flow assumption is made in order to match the cost of products sold during the accounting period to the revenue generated from the sales and to assign a dollar value to the inventory remaining for sale at the end of the accounting period. - Unlike the case for some accounting rules--in which a firm is allowed to use one method for tax and another method for reporting purposes--a company that elects LIFO to figure taxable income must also use LIFO for reported income. - The many companies that have switched to LIFO from other methods are apparently willing to trade lower reported earnings for the positive cash benefits resulting from LIFO's beneficial tax effect. - The method used to value inventory will generally be shown in the note to the financial statements relating to inventory. - If the actual market value of inventory falls below cost, as determined by the cost flow assumption, then inventory will be written down to market price. - Companies using IFRS have similar rules for lower of cost or market, however a key difference is that inventory reductions may be reversed if the market recovers, but the inventory carrying amount cannot exceed the original cost. - Companies are allowed to use more than one inventory valuation method for inventories. - LIFO is not an acceptable inventory valuation method under IFRS and, as such, a firm may find it more convenient for reporting purposes to use methods acceptable in the country in which it operates.

Retained Earnings

- The retained earnings account is the sum of every dollar a company has earned since its inception, less any payments made to shareholders in the form of cash or stock dividends. - Retained earnings do not represent a pile of unused cash stashed away in corporate vaults; retained earnings are funds a company has elected to reinvest in the operations of the business rather than pay out to stockholders in dividends. Beginning retained earnings +/- Net income (loss) - Dividends = Ending retained earnings

Other Equity Accounts

- These include preferred stock, accumulated other comprehensive income, and treasury stock. - Preferred stock usually carries a fixed annual dividend payment but no voting rights. - Other comprehensive income is reported in a separate equity account on the balance sheet generally referred to as accumulated other comprehensive income/(expense). - This account includes up to four items: 1. unrealized gains or losses in the market value of investments in available-for-sale securities 2. any change in the excess of additional pension liability over recognized prior service cost 3. certain gains and losses on derivative financial statements 4. foreign currency translation adjustments resulting from converting financial statements from a foreign currency into US dollars. - If the repurchased shares are not retired, they are designated as treasury stock and are shown as an offsetting account in the stockholders' equity section of the balance sheet.

Property, Plant, and Equipment

- This category encompasses a company's fixed assets (also called tangible, long-lived, and capital assets)-- those assets not used up in the ebb and flow of annual business operations. - These assets produce economic benefits for more than one year, and they are considered "tangible" because they have a physical substance. - Fixed assets other than land (which has a theoretically unlimited life span) are "depreciated" over the period of time they benefit the firm.

Cash and Cash Equivalents

- Two accounts, cash and cash equivalents, are generally combined on the balance sheet. - The cash account is exactly that, cash in any form--cash awaiting deposit or in a bank account. - Cash equivalents are short-term, highly liquid investments, easily turned into cash with maturities of thee months or less. - Money market funds, US Treasury bills, and commercial paper (unsecured short-term corporate debt) generally qualify as cash equivalents.

Current Maturities of Long-Term Debt

- When a firm has bonds, mortgages, or other forms of long-term debt outstanding, the portion of the principal than will be repaid during the upcoming year is classified as a current liability. - The note lists the amount of long-term debt outstanding, less the portion due currently, and also provides the schedule of current maturities for the next five years.

Consolidation

- When a parents owns more than 50% of the voting stock of a subsidiary, the financial statements are combined for the companies even though they are separate legal entities. - The statements are consolidates because the companies are in substance one company, given the proportion of control by the parent. - Where less than 100% ownership exists, there are accounts in the consolidated balance sheet and income statement to reflect the minority or non controlling interest in net assets and income.

Accelerated ^5

Cost less accumulated depreciation x twice the straight-line rate = Depreciation expense **info** - The fixed asset account on the balance sheet is shown at historical cost less accumulated depreciation, and the annual depreciation expense is deducted on the income statement to determine net income. - Most firms use the straight line method of depreciation for financial reporting as this method reduces volatility in the profit numbers from year to year. - Because leasehold improvements revert to the property owner when the lease term expires, they are amortized by the lessee over the economic life of the improvement or the life of the lease, whichever is shorter. - A firm that manufactures products would likely be more heavily in capital equipment than a retailer or wholesale.

Straight line

Depreciable base (cost less salvage value) / Depreciation period

Balance Sheet Date

The balance sheet is prepared at a point in time at the end of the accounting period, a year, or a quarter.