Ch. 4: The Balance Sheet and the Statement of Shareholders' Equity

Accounts payable turnover in days

365 days ÷ Accounts payable turnover

Accounts receivable turnover in days

365 days ÷ Accounts receivable turnover

Inventory turnover in days

365 days ÷ Inventory turnover

When a resource does not meet the definition of an asset or cannot be measured reliably

GAAP and IFRS do not permit recognition of the resource as an asset

Intracompany comparisons

a method of evaluating a company's current financial performance and condition by comparing them with the company's past

Intercompany comparisons

a method of evaluating a company's performance by comparing it with that of key competitors, with the industry averages, or with the results in related industries

Balance sheet (statement of financial position)

a report of the resources of a company (assets) and the claims on the company (liabilities and shareholders' equity) as of a specific date, usually the last day of the fiscal quarter or the fiscal year

Nonmonetary assets (nonfinancial assets)

assets other than cash and claims on future cash flows, such as inventory, property, plant, and equipment, and intangibles

Quick assets

assets that can be converted into cash, usually within 90 days (typically including cash and equivalents, short-term investment securities and receivables)

Monetary assets (financial assets)

assets that represent cash or claims on future cash flows, such as accounts receivable and investment securities

A resource that does not meet all three asset recognition criteria

cannot be capitalized as an asset and must be expensed

Contributed capital

capital recognized when a shareholder acquires shares directly from the corporation rather than when the investor purchases shares on the stock market or from another investor

Time-series analysis

comparisons of a firm's financial position and performance over time

Working capital

current assets - current liabilities

Equitable obligations

ethical or moral

The statement of cash flows

explains changes in financial position in terms of cash inflows and outflows during the period

Mixed attribute measurement model

financial reporting uses a variety of different measurement attributes (historical costs, fair values, and others) to measure and report assets and liabilities on the balance sheet, in order to increase the relevance and representational faithfulness of the reported information

Common-size analysis

financial statement users compute the percentage amounts of each item on the financial statement relative to the relevant total for that statement

Constructive obligations

inferred from the facts

Liquidity ratios

measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash

Risk and financial flexibility

o Assess the leverage and long-run solvency of a company o Provide evidence of the risk of capital invested in the company by financial stakeholders, including lenders, preferred shareholders, and common shareholders

Fair value measurement hierarchy

o Level 1 inputs --- quoted prices in active markets for identical assets or liabilities on the measurement date --- provide the most representationally faithful evidence of fair value and is to be used whenever available o Level 2 inputs --- observable market prices for similar assets or liabilities in active markets, or other observable inputs, such as interest rates, for the asset or liability --- to be used when Level 1 inputs are not readily available o Level 3 inputs --- the company's estimates and assumptions used to calculate fair value for an asset or a liability --- should be used to measure fair value only when Level 1 or Level 2 inputs are not available, or the costs of obtaining them exceed the benefits --- reflect the company's assumptions and estimates about how market participants would price the asset or liability --- should be developed based on the best information available, which might include the company's own data about the expected cash flows and the appropriate discount rate

To provide relevant and faithfully represented information about assets, liabilities, and shareholders' equity to investors, lenders, and other creditors, the company must determine:

o What elements are recognized on the balance sheet o How the elements are measured (valued) o Where to classify and report the elements on the balance sheet.

Financial leverage

o a company's use of debt to increase earnings by investing borrowed money in assets that generate profits that are greater than the after-tax cost of the debt and using those excess profits to increase the return on equity for the company's shareholders o types --- debt-to-assets ratio --- debt-to-equity ratio o sometimes the ratios will include only formal debt financing instruments, including short-term borrowings and long-term bonds, notes, mortgages, and lease obligations

Noncontrolling interests

o a component of shareholders' equity that only arises when one company (known as a parent company) owns a majority of the common shares of another company (known as a subsidiary company) but does not own 100% of the shares o represent the equity invested in the subsidiary by noncontrolling investors

Rate of change analysis

o a financial statement user computes the percentage rates of change in a company's financial position and performance over time o frequently used to compute growth rates in items reported on the balance sheet and on the income statement o enables users to identify which items on the balance sheet and income statement are growing quickly or slowly o the current year amount for each financial statement item is computed as a percentage rate of change from the prior year amount o for multiple years, the percentage rate of change from year to year is computed for each year o divide the most recent year amount by the base year amount. Take the square root of the result. From that result, subtract 1 and then multiply by 100 to convert it to the compound percentage rate of growth over that period o if a base figure is zero or negative, although an amount of change can be determined, it cannot be expressed as a valid percentage change because dividing by zero or a negative number is meaningless o for items with small base amounts, a relatively small dollar change may result in a very high percentage rate of change, thus potentially making the item appear more significant than may be warranted.

Transfer

o a liability must involve a responsibility that will be settled by a sacrifice involving the transfer of assets, provision of services, or other use of assets at a specified or determinable date, on occurrence of a specified event, or on demand o the company does not need to know the specific identity of the creditor for a liability to exist.

Quick ratio

o a test of a company's liquidity and short-term debt-paying abilities o only the current assets that may be easily converted into cash are used in the calculation o computes the number of dollars in quick assets for each dollar in current liabilities o Quick Ratio = Quick Assets ÷ Current Liabilities o Quick Ratio = (Current Assets - Inventories - Prepaid items) ÷ Current Liabilities

Accounts receivable turnover ratio

o an indicator of how efficiently the company collects its receivables and converts them back into cash o Accounts Receivable Turnover = Total Credit Sales ÷ Average Accounts Receivable

Incurred

o an obligating transaction, event, or arrangement must have occurred o once a liability has been incurred, it continues to be a liability until the company settles it or another event eliminates the company's obligation

Fair value measurement

o assumes that the asset could be sold or the liability could be settled in a hypothetical transaction on the measurement date o can be extremely relevant and representationally faithful when based on observable prices in orderly liquid markets for stocks, bonds, securities, commodities, derivatives, and other items o three-tiered hierarchy within U.S. GAAP and IFRS that distinguishes among different inputs for determining fair values

Major Financial Statements

o balance sheet, which reports the financial position at the end of the accounting period o income statement, which reports the results of the income-producing activities for the accounting period o comprehensive income statement, which reports the comprehensive income for the accounting period, including net income and various other comprehensive income items o statement of cash flows, which shows the cash inflows and cash outflows from operating, investing, and financing activities for the accounting period o statement of shareholders' equity, which reports the ending amounts and changes in each item of shareholders' equity for the accounting period

Executory contracts

o contracts in the process of being fulfilled, such as a purchase order o under U.S. GAAP and IFRS, companies do not recognize executory contracts until the company receives the benefits and becomes obligated to pay for them

Favorable financial leverage

o earning a return on borrowed funds that exceeds the cost of borrowing the funds o occurs when the company borrows money from creditors at an interest rate (net of income taxes) that is lower than the return the company can earn by using that capital in its operations o as the financial leverage ratio increases, there is a trade-off in that the company becomes riskier o high leverage creates risk, such that if a company's profits and cash flows suddenly fall, the company may face difficulty in making interest and principal payments and could face bankruptcy

GAAP and IFRS do not permit recognition of the resource as an asset

o employees—not obtained or controlled by the company (e.g., they can quit) o unfilled purchase orders placed with suppliers—not fulfilled with a past transaction o a high-quality reputation with employees, customers, or the community—not reliably measurable

Common-size income statement

o expresses all of the amounts as percentages of total revenues o reveals profit margins as a percentage of total revenues

Common-size balance sheet

o expresses the asset, liability, and equity amounts as percentages of total assets o reveals the proportions each asset represents of total assets and the proportions of financing provided by each type of liability and equity account

Measurement methods that reflect current values or a combination of historical and current values

o fair value (assets and liabilities) o present value (assets and liabilities) o current replacement cost (assets) o net realizable value (assets)

Cross-section analysis

o financial statement analysis involving intercompany comparisons, in which one companies' financial statements and ratios are compared to peer companies, competitors, and/or industry-averages o easy to identify trends or changes in the relationships between items over several periods

Tangible assets

o have physical substance o inventories, land, buildings, equipment, and vehicles

Measurement methods that reflect historical values

o historical cost or acquisition cost (assets) and historical proceeds or originally incurred obligation amounts (liabilities) o allocated historical amounts (for assets and liabilities allocated over time) o initial present value and adjusted present value (assets and liabilities that represent future cash flows)

Total asset turnover ratio

o indicates how efficiently a company generates sales relative to its total asset base o Total Asset Turnover = Total Revenues ÷ Average Total Assets

Fixed asset turnover ratio

o indicates the average number of sales dollars the company generated per average dollar invested in fixed assets o Fixed Asset Turnover = Total Revenues ÷ Average Net Fixed Assets

Inventory turnover ratio

o indicates the average number of times the inventory "turned over" or sold during that period o higher inventory turnover indicates the company --- was more effective in managing production and supply chain operations --- tied up a lower amount of cash in inventory, and --- had a shorter operating cycle to replenish cash o Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

Contingent obligations

o liabilities that are probably but not certain obligations o obligations that arise conditional on something else occurring, such as a performance-based bonus

Debt-to-equity ratio

o measures the number of dollars of debt financing per dollar of financing from total common shareholders' equity o Total Liabilities ÷ Total Common Shareholders' Equity

Accounts payable turnover ratio

o measures the number of times accounts payable turn over during the year o Accounts Payable Turnover = Inventory Purchases ÷ Average Accounts Payable

Debt-to-assets ratio

o measures the percentage of total assets financed by creditors o Total Liabilities/Total Assets

Return on common equity

o measures the profitability of the company relative to the amount of equity capital invested by the common shareholders o Net Income / Average Total Common Shareholders' Equity

The elements of the comprehensive income statement

o primarily unrealized gains and losses o measured in terms of changes in the values of certain types of assets and liabilities

Asset recognition criteria

o probable future economic benefit o control o acquisition

Financial statement analysis ratios

o proportionate relationships between financial statements amounts o used to evaluate a company's --- return on investment --- risk --- liquidity --- financial flexibility --- operating capability o types --- return on investment --- return on assets --- return on common equity

Adjusted historical cost

o recognizing an expense for the portion of the asset used up each period and decrease the balance sheet value of the asset to reflect the benefits that have been consumed o for property, plant, and equipment, the use of the asset is recognized through depreciation expense, and the acquisition cost is adjusted through the contra-asset account, Accumulated Depreciation o for intangible assets, the use of the asset is recognized through amortization expense, and the acquisition cost is adjusted through the contra-asset account, Accumulated Amortization o for prepaid assets like insurance and rent, the acquisition cost of the asset is reduced ratably for the amount consumed and expensed each period o managers must exercise considerable judgment, estimating the expected useful life and salvage value of productive assets as well as selecting a depreciation or amortization method

Shareholders' equity

o represents the ownership interest in a company o does not exist apart from the company assets and liabilities o categories --- contributed capital --- earned capital --- noncontrolling interests

The elements of the income statement

o revenues, expenses, gains and losses, and net income o measured in terms of changes in assets and liabilities

Historical cost (acquisition cost)

o the amount paid initially to acquire an asset o includes all costs required to prepare the asset for its intended use, including shipping, installation, setup, and testing o the amount of the originally incurred obligation o ideal at the time assets are obtained or liabilities are incurred

Liabilities

o the company's obligations owed to creditors o the probable future sacrifices of economic benefits arising from present obligations of a company to transfer assets or provide services in the future to other entities as a result of past transactions or events

Current ratio

o the most commonly used ratio to evaluate liquidity o indicates the number of dollars in current assets for each dollar in current liabilities o indicates the relative relationship between the current assets and current liabilities, allowing comparisons of liquidity across different sized companies o too high relative to the company's strategy and similar companies within the same industry may indicate inefficient management of current assets o too low may indicate liquidity problems and difficulty in paying current liabilities when they come due o Current Ratio = Current Assets ÷ Current Liabilities

Fair value

o the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date o a measure of market-based exit value, which is the amount for which a company could sell an asset or pay to settle or transfer a liability

Assets

o the probable future economic benefits obtained or controlled by a company as a result of past transactions or events o the economic resources used to carry out a company's business activities

Probable future economic benefit

o the resource must be expected to contribute future economic benefits either directly or indirectly to the company o may exist because the asset is expected to: --- be used to cover costs, acquire other resources, or settle liabilities (e.g., cash) --- be collected in cash (e.g., accounts receivable) --- be exchanged for cash or something else of value to the company (e.g., inventory, investment securities) --- be used in producing goods or services (e.g., prepaid expenses, property, plant, and equipment) convey legal rights (e.g., a patent or license) --- increase the value of other assets (e.g., brand name or goodwill)

Nonavoidable

o the responsibility must obligate the company so that it has little or no discretion to avoid the future sacrifice. Although most liabilities involve legal rights and duties, some are the result of equitable (ethical or moral) obligations or constructive (inferred from the facts) obligations o the company must be bound by a legal, equitable, or constructive responsibility to transfer assets or provide services

Acquisition

o the transaction or event giving the company the right to or control over the benefit must have occurred o it continues to be an asset until it is exchanged or used up, or until some other event destroys the future benefits or removes the company's ability to obtain or control the future benefits

Liability recognition criteria

o transfer o nonavoidable o incurred

Intangible assets

o usually legal substance or reputation o patents, trademarks, licenses, and goodwill

Present value

o value of monetary assets and liabilities represent amounts of cash the company expects to receive or is obligated to pay in the future o discounts the expected future cash flows to a present value to report the monetary assets and liabilities in terms of current cash equivalent values o for monetary assets and liabilities due within 1 year, U.S. GAAP and IFRS permit companies to ignore discounting for the time value of money

Fair value option

o values of certain types of assets and liabilities (such as trading securities and investment securities available for sale) for financial instruments (such as loans, notes receivable or payable, and bonds receivable or payable) o upon acquisition of a financial asset or inception of a financial liability, companies can elect to report the financial instrument at fair value (with subsequent changes in fair values to flow through earnings) o once elected, the company must remain on that measurement basis for the life of that financial asset or liability o most useful for financial institutions (e.g., banks and insurers) because the majority of their assets and liabilities are financial in nature

Adjusted present values

o values that reflect the passage of time o zero-coupon notes receivable or notes payable do not trigger interest cash flows until the notes mature, at which time all of the accumulated interest is paid, along with the principal of the note

Financial statements other than the balance sheet

report changes in the financial position of the company during the period

The statement of shareholders' equity

reports owners' claims on the company and how those claims changed during the period

Earned capital

retained earnings and, for some companies, accumulated other comprehensive income

Market-based exit value

the amount for which a company could sell an asset or pay to settle or transfer a liability

Rate of return on investment

the amount of profit earned during a period relative to the amount of capital invested, such as the rate of return on assets or the rate of return on common equity

Financial position

the assets, liabilities, and owners' equity of a firm at a point in time

Operating cycle

the average length of time taken by a company to spend cash, purchase or produce inventory, sell the inventory, and collect the receivables, converting them back into cash—most often a year or less

Service potential

the capacity to provide services or benefits to the company that uses them

Control

the company can deny or restrict the ability of others to use the asset

Recognition

the process of formally recording and reporting an item in the financial statements of a company

Equity

the residual interest in the assets of a company that remains after deducting its liabilities

The objective of U.S. GAAP and IFRS

to provide the most relevant information that can be faithfully represented in the financial statements

Operating capability ratios (efficiency ratios or activity ratios)

used to evaluate the efficiency with which the company uses its economic resources to generate revenues.