Ch 3
Balance Sheet: Usefulness Grouping provides useful information about:
- Liquidity—the ability of a company to convert its assets to cash - Long-term solvency—whether a company will be able to pay all its liabilities including its long-term liabilities• Financial flexibility —the ability of a company to alter cash flows in order to take advantage of unexpected investment opportunities and needs
"Balance Sheet Limitations" Two primary reasons that the balance sheet does not equal the company's market value are:
1. Many assets are measured at their historical costs rather than the amounts for which the assets could be sold 2. Many aspects of a company may represent valuable resources, but these items are not recorded as assets in the balance sheet and therefore have zero book value
• Four basic types of auditors' reports:
1. Unqualified 2. Unqualified with an explanatory or emphasis paragraph 3. Qualified 4. Adverse or disclaimer
Balance Sheet Limitations
A company's book value, assets minus liabilities as shown in the balance sheet, usually will not directly measure the company's market value
Working Capital
A popular measure of a company's ability to satisfy its short-term obligations is the relation between current assets and current liabilities
Acid-test ratio example: Nike's quick assets total $9,856 ($3,808 + 2,371 + 3,677). The acid-test ratio can be computed as follows:
Acid-test ratio = $9,856/$5,474= 1.80
Accounts Receivable
Amounts to be received in the future due to the sale of goods or services • Often referred to as trade receivables • Nontrade receivables result from loans by the company to individuals and other entities
Classification of Elements within a Balance Sheet
Assets = Liabilities + Shareholders' Equity 1. Current assets 2. Long-term assets 1. Current liabilities 2. Long-term liabilities 1. Paid-in capital 2. Retained earnings
Cash and Cash Equivalents
Currency, checks, short-term bank accounts, and investments that mature within three months or less.
•Common measures of liquidity are:
Current ratio =Current assets/Current liabilities Acid-test ratio (or quick ratio) Quick assets/Current liabilities
Short-term investments
Investments that are readily marketable and intended to be converted into cash within the next year or operating cycle, whichever is longer.
• Common solvency ratios are:
Debt to equity ratio= Total liabilities/Shareholders' equity
Management's Discussion and Analysis & Responsibilities
Management's Discussion and Analysis • Provides management's biased but informed perspectives on significant events, trends, and uncertainties pertaining to: a) Operations b) Liquidity c) Capital resources Management's Responsibilities Section • Asserts the responsibility of management for the information contained in the annual report as well as an assessment of the company's internal control procedures • Requires corporate executives to personally certify the financial statements as per the Sarbanes-Oxley Act of 2002
times interest earned ratio equation
Net income + Interest expense + Income taxes/Interest expense
Current Ratio Nike reported current assets (in millions) of $16,061 and current liabilities of $5,474 as of May 31, 2017
Nike's current ratio of 2.93 indicates that the company has $2.93 of current assets for each $1 of current liabilities.
ACCOUNTS PAYABLE
Obligations to suppliers of merchandise or services purchased on account •Payment usually due in 30 to 60 days
Compensation of Directors and Top Executives
SEC requirements provide for disclosures on compensation to directors and executives • A proxy statement must be provided each year to all shareholders, usually along with the annual report - Statement invites shareholders to the annual meeting to elect board members and to vote on issues or to vote by proxy - Includes compensation and stock option information for directors and top executives
Specific Disclosure Notes
Summary of Significant Accounting Policies •Conveys valuable information about a company's choices from among various alternative accounting methods Subsequent Events •Occurs after a company's fiscal year-end but before the financial statements are issued Examples of Subsequent Events • Issuance of debt or equity securities • Business combination or the sale of a business • Sale of assets • Event that sheds light on the outcome of a loss contingency
Which disclosure provides an independent and professional opinion about the fairness of the representations in the financial statements and about the effectiveness of internal controls? a. Auditors' report b. Proxy statement c. Management's discussion and analysis d. Summary of significant accounting policies
The correct answer is a. Only the auditors' report would represent an independent opinion. The other items are prepared by management and thus are not considered independent.
Where is management's discussion and analysis located? a. Preceding the financial statements and audit report in the annual report b. In the annual chairman's letter to shareholders c. At the end of the annual report as an appendix d. At the beginning of the proxy statement
The correct answer is a. Management's discussion and analysis is presented in the company's annual 10-K filing with the SEC. It will precede the consolidated financial statements and audit report.
Which of the following would be commonly reported in the summary of significant accounting policies note? a. Errors and fraud b. Method used to record depreciation c. Subsequent events d. Related-party transactions
The correct answer is b. The summary of significant accounting policies details key policies and methods including inventory costing, depreciation methods, and revenue recognition. Disclosures such as subsequent events, related-party transactions, and errors or fraud, if relevant, are explained in separate notes.
The key distinction between current liabilities and long-term liabilities is: a. The amount of the obligation to be satisfied—large versus small b. To whom the obligation is owed—those inside versus those outside of the company c. The length of time until the obligation is expected to be satisfied—less than one year versus more than one year, or operating cycle if longer d. The nature of the obligation—determinable amount versus estimated amount
The correct answer is c. The key distinction is the time period in which the obligation will be satisfied. If it will be satisfied within one year or operating cycle, it should be classified as current rather than long-term.
Which of the following is true regarding GAAP and IFRS? a. There are more differences than similarities between U.S. GAAP and IFRS b. IFRS specifies a maximum number of items to be reported in the balance sheet c. Many companies reporting under IFRS present noncurrent assets before current assets in the balance sheet d. U.S. GAAP specifies a minimum number of items to be reported in the balance sheet
The correct answer is c. There are more similarities than differences between GAAP and IFRS; IFRS specifies a minimum number of items to be reported in the balance sheet; most IFRS filers present noncurrent assets before current assets on the balance sheet which is a direct contrast to the presentation under U.S. GAAP.
Geisner Inc. has total assets of $1,000,000 and total liabilities of $600,000. The industry average debt to equity ratio is 1.20. Calculate Geisner's debt to equity ratio and indicate whether the company's default risk is higher or lower than the average of other companies in the industry. a. 0.60; Higher default risk b. 0.60; Lower default risk c. 1.50; Higher default risk d. 1.50; Lower default risk
The correct answer is c: Debt to equity ratio= 600,000/400,000=1.50 Equity = Assets − Liabilities = $1,000,000 − $600,000 = $400,000
Which of the following transactions would increase a company's liquidity ratios? a. Receive cash from customers on accounts receivable b. Purchase office supplies with cash c. Pay dividends to shareholders d. Borrow cash by signing a three-year note
The correct answer is d. Cash increases while current liabilities remain the same, thus increasing the company's ability to pay existing short-term debt.
Which of the following describes the risk that the company cannot pay its obligations when they come due? a. Operational risk b. Cash management risk c. Horizontal risk d. Default risk
The correct answer is d. Default risk describes the risk the company cannot pay its obligations when they come due, and operational risk relates to how a company can withstand various events.
Times Interest Earned Ratio Example • Nike reports the following ($ in millions): Net income 4,240 Interest expense +59 income tax +646 ------------- $4945
The times interest earned ratio for Nike can be computed as follows: Times interest earned ratio 4945/59= 83.81
Financial Statement Analysis
Various tools and techniques are needed to formulate predictions - Common methods include: 1. Comparative financial statements —financial statements are presented for the preceding year and often the previous two years 2. Horizontal analysis—each item is presented as a percentage of a base year amount 3. Vertical analysis—each item is presented as a percentage of a total 4. Ratio analysis—financial statement items are converted to ratios
One measure of this is working capital
Working Capital = Current Assets − Current Liabilities Example • Nike's working capital (in millions) is $10,587. This amount is computed as Nike's current assets of $16,061 minus its current liabilities of $5,474
Which of the following is most likely to be reported as a long-term asset? a. Accounts receivable b. Buildings c. Prepaid rent d. Inventory
b. Buildings The correct answer is b. Buildings generally benefit the company for several years. The other items listed above are generally realized as cash or consumed within one year.
Which of the following is a subclassification of assets in the balance sheet? a. Cash and cash equivalents b. Revenue c. Current assets d. Disposable assets
c. Current assets The correct answer is c. Current assets are the first subclassification of assets presented in the balance sheet. Cash and cash equivalents are reported within the category of current assets. Revenue is reported in the income statement rather than the balance sheet. Although companies may dispose of many assets at will, accountants do not classify assets as "disposable."
Which of the following represents tangible, long-lived assets used in the operations of the business? a. Current assets b. Investments c. Property, plant, and equipment d. Intangible assets
c. Property, plant, and equipment The correct answer is c. Current assets are not long-lived, investments are not used directly in operations, and intangible assets have no physical substance.
Current assets include cash and all other assets expected to become cash or be consumed: a. Within one year b. Within one operating cycle c. Within one year or one operating cycle, whichever is shorter d. Within one year or one operating cycle, whichever is longer
d. Within one year or one operating cycle, whichever is longer
Investments
• Assets that are not used directly in the operations of the business Examples- Investments in equity and debt securities of other corporations - Land held for speculation - Long-term receivables - Cash set aside for special purposes
Auditors' Report
• Auditors examine financial statements and the internal control procedures - They attest to the fairness of the financial statements - Results in an opinion stated in the auditors' report
Unqualified with an Explanatory Paragraph
• Circumstances where the auditor believes the financial statements are in conformity with GAAP (unqualified), but other important information needs to be emphasized to financial statement users • Situations include: - Lack of consistency - Going concern - Material misstatement - An audit opinion may also include a paragraph on emphasis of a matter.
Unqualified Auditors' Reports
• An auditor issues an unqualified (or "clean") opinion when the auditor has undertaken professional care to ensure that the financial statements are presented in conformity with generally accepted accounting principles (GAAP) • Professional care would include: - Sufficient planning of the audit - Understanding the company's internal control procedures - Gathering evidence to attest to the accuracy of the amounts reported in the financial statements
Prepaid Expenses
• Arises when a company incurs a cost of acquiring an asset in one period that will not be expensed until a future period • Current or noncurrent depends on the period in which the item is consumed Examples: Supplies, prepaid rent, and prepaid insurance
Debt to Equity Ratio
• Compares resources provided by creditors with resources provided by owners •Indicates the extent of reliance on creditors, rather than owners •Provides a measure of creditors' protection in the event of insolvency •Other things being equal: the higher the ratio, the higher the risk
International Financial Reporting Standards: Balance Sheet
• Differences in balance sheet presentation according to U.S. GAAP and those prepared applying IFRS include: - International standards specify a minimum list of items to be presented in the balance sheet • U.S. GAAP has no minimum requirements - IAS No. 1, revised, changed the title of the balance sheet to statement of financial position • Some U.S. companies use this title as well - Balance sheets prepared using IFRS often report noncurrent items first • U.S. GAAP presents current assets before noncurrent assets, and current liabilities before noncurrent liabilities
long-term liabilities
• Long-term liabilities are obligations that are (a) due to be settled or (b) have a contractual right by the borrowing company to be settled in more than one year (or operating cycle, if longer) after the balance sheet date • Impact on future cash flows and long-term solvency is assessed by reporting payment terms, interest rates, and other details in a disclosure note Examples Long-term notes, bonds, pension obligations, and lease obligations, among others
Debt to Equity Ratio Example
• Nike's liabilities (in millions) are $10,852 and stockholders' equity is $12,407 • The debt to equity ratio can be computed as follows: Debt to equity ratio = $10,852/12,407 = 0.87 Industry average debt to equity ratio 0.95 Nike's debt-to-equity ratio 0.87 0.95>0.87 - Nike has a lower default risk
Current liabilities include
• Obligations that are expected to be satisfied through the use of current assets or the creation of other current liabilities • Expected to be satisfied within one year or the operating cycle, whichever is longer Examples - Accounts payable - Notes payable (short-term borrowings) - Deferred revenues - Accrued liabilities - Currently maturing portion of long-term debt
Acid-Test (or Quick) Ratio does what ?
• Provides a more stringent indication of a company's ability to pay its current obligations • Numerator excludes inventories, prepaid items, and restricted cash • Numerator includes (unrestricted) cash, short-term investments, and accounts receivable— These are referred to as "quick assets"
Other Types of Current Liabilities DEFERRED REVENUES
• Represent cash received from a customer for goods or services to be provided in a future period Example: Sale of a gift card; revenue is recognized when gift card is redeemed or expires
Other Types of Current Liabilities ACCRUED LIABILITIES
• Represent obligations created when expenses have been incurred but will not be paid until a subsequent reporting period Examples: Accrued salaries payable, accrued interest payable, and accrued taxes payable
Other long-term assets
• Represents a catch-all classification of long-term assets that were not reported separately in one of the other long-term classifications - Often includes long-term prepaid expenses (deferred charges) - Might also include long-term investments not material in amount •A key to understanding which category an asset is reported is management intent
Times Interest Earned Ratio info
• Used in conjunction with the debt to equity ratio To remain solvent or take on more debt, a company needs to have funds available to pay interest charges • If income is many times greater than interest expense, creditors' interests are more protected than if income just barely covers this expense
Relationship between Risk and Profitability
• While there are default risks associated with borrowing, a company can use those borrowed funds to provide greater returns to its shareholders - This is referred to as favorable financial leverage and is a very common (but risky) business activity • When a company needs money, the alternatives are debt and equity - Sometimes more debt can mean a higher return on shareholders' equity
Balance Sheet: Usefulness
•Assets are classified according to common characteristics
Annual Report Disclosures
•At the end of each fiscal year, companies with public securities are required to provide shareholders with an annual report - The annual report includes • Financial statements such as the balance sheet • Additional disclosures, which may include items relating to business conditions, risk factors, legal proceedings, stock performance, and internal control procedures
Disclosure Notes
•Explain data presented in financial statements themselves, or provide information not directly related to any specific item in the statements Examples: - Pension plans - Leases - Long-term debt - Income taxes- Investments - Property, plant, and equipment, -employee benefit plans •Must include a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions
Intangible Assets
•Generally represent exclusive rights •Valuable resources in generating future revenues •Reported in the balance sheet net of accumulated amortization •Can be purchased or developed internally Examples: Patents, copyrights, trademarks, franchises, and goodwill
Liquidity Ratios
•Liquidity—Liquidity most often refers to the ability of a company to convert its assets to cash to pay its current obligations.
Shareholders' Equity
•Owners' equity is simply total assets minus total liabilities: Assets − Liabilities = Shareholders' Equity •Arises primarily from: 1. Paid-in capital and 2. Retained earnings •Sometimes referred to as net assets or book value •Includes other equity components such as accumulated other comprehensive income (AOCI)
Solvency Ratios
•Provide some indication of the riskiness of a company with regard to its ability to pay its long-term debts
Balance Sheet
•Reports a company's financial position at a point in time •Provides an organized list of assets, liabilities, and equity—grouped according to common characteristics
Other Audit Reports
•Some audits result in the need to issue other than an unqualified opinion due to exceptions such as: a) Nonconformity with generally accepted accounting principles b) Inadequate disclosures c) A limitation or restriction of the scope of the audit examination • In these situations the auditor will issue a(n): - Qualified opinion - Adverse opinion - Disclaimer
Noteworthy Events and Transactions
•Some transactions and events occur only occasionally but are potentially important to evaluating a company's financial statements •In this category are: 1. Related-party transactions—Transactions between the company and owners, management, families of owners or management, affiliated parties, etc. 2. Errors and fraud—Misstatements that are unintentional (errors) or intentional (fraud) 3. Illegal acts—Bribes, kickbacks, illegal contributions to political candidates, and other violations of the law •The more frequent of these is related-party transactions
Notes receivable
•Supported by a formal agreement or note that specifies payment terms
Property, Plant, and Equipment
•Tangible, long-lived assets used in the operations of the business •Reported as a single amount in the balance sheet, at original cost less accumulated depreciation Examples: Land, buildings, equipment, machinery, furniture, and vehicles, as well as natural resources, such as mineral mines, timber tracts, and oil wells
Elements of Current Assets
•The components of current assets are listed in decreasing order of liquidity- Typical components include: •Cash and cash equivalents •Short-term investments •Accounts receivable •Inventory •Prepaid expenses
Liquidity ratios are used to ?
•These ratios provide information about a company's ability to pay its short-term obligations
NOTES PAYABLE
•Written promises to pay cash at some future date •Usually require the payment of explicit interest in addition to the original obligation amount