Module 5 - CHAPTER 5 Balance Sheet and Statement of Cash Flows

The balance sheet provides a basis for computing rates of return and evaluating the capital structure of the enterprise.

Analysts also use information in the balance sheet to assess a company's risk1 and future cash flows. In this regard, analysts use the balance sheet to assess a company's liquidity, solvency, and financial flexibility.

CF statement's value is that it helps users evaluate liquidity, solvency, and financial flexibility.

As stated earlier, liquidity refers to the "nearness to cash" of assets and liabilities. Solvency is the firm's ability to pay its debts as they mature. Financial flexibility is a company's ability to respond and adapt to financial adversity and unexpected needs and opportunities.

Holden Company purchased 150 acres of land on the outer edge of a growing city. Holden expects the value of this land to appreciate by 500% over the next three years. How would you expect Holden to report the value of this land on their balance sheet?

At historical cost.

Jake Stratta is an investor who is interested in purchasing a large block of shares of Hamilton Industries. If Jake wants to predict Hamilton's future cash flows before he makes his investment, which financial statement should he look at?

Balance Sheet

Owens International Resources is preparing a Summary of Significant Accounting Policies to go with their financial statements for the current fiscal year. The reason they need to do this is?

Because they have multiple accounting policies that they need to disclose.

Current assets are presented in the balance sheet in order of liquidity

Cash and cash equivalents -Fair value Short-term investments -Generally, fair value Receivables - Estimated amount collectible Inventories - Lower-of-cost-or-net realizable value/market Prepaid expenses Cost

Cash is generally considered to consist of currency and demand deposits (monies available on demand at a financial institution).

Cash equivalents are short-term highly liquid investments that will mature within three months or less.

Net cash provided by operating activities is the excess of cash receipts over cash payments from operating activities.

Companies determine this amount by converting net income on an accrual basis to a cash basis.

Major limitations of the balance sheet 2

Companies use judgments and estimates to determine many of the items reported in the balance sheet. For example, in its balance sheet, Dell estimates the amount of receivables that it will collect, the useful life of its warehouses, and the number of computers that will be returned under warranty.

Companies group investments in debt securities into three separate portfolios for valuation and reporting purposes:

Held-to-maturity: Debt securities that a company has the positive intent and ability to hold to maturity. Trading: Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences. Available-for-sale: Debt securities not classified as held-to-maturity or trading securities.

account form

It lists assets, by sections, on the left side, and liabilities and stockholders' equity, by sections, on the right side. The main disadvantage is the need for a sufficiently wide space in which to present the items side by side.

Major Types of Ratios

Liquidity Ratios. Measures of the company's short-term ability to pay its maturing obligations. Activity Ratios. Measures of how effectively the company uses its assets. Profitability Ratios. Measures of the degree of success or failure of a given company or division for a given period of time. Coverage Ratios. Measures of the degree of protection for long-term creditors and investors.

Major limitations of the balance sheet 1

Most assets and liabilities are reported at historical cost. As a result, the information provided in the balance sheet is often criticized for not reporting a more relevant fair value. For example, Georgia-Pacific owns timber and other assets that may appreciate in value after purchase. Yet, Georgia-Pacific reports any increase only if and when it sells the assets.

Noncurrent Assets

Noncurrent assets are those not meeting the definition of current assets.

1. Assets.

Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

2. Liabilities.

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Which of the following balance sheet formats lists the assets on top and the liabilities and stockholders' equity on the bottom?

Report Form

The most common balance sheet formats include which of the following?

Report form and account form.

3. Equity.

Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.

Balance sheet accounts are classified.

That is, balance sheets group together similar items to arrive at significant subtotals.

Revenue Recognition

The GAAP principle that revenue is recorded on the date it is earned even if cash has not been received.

Solvency

The ability of a company to pay interest as it comes due and to repay the balance of debt due at its maturity. -refers to the ability of a company to pay its debts as they mature. For example, when a company carries a high level of long-term debt relative to assets, it has lower solvency than a similar company with a low level of long-term debt. Companies with higher debt are relatively more risky because they will need more of their assets to meet their fixed obligations (interest and principal payments).

Major limitations of the balance sheet 3

The balance sheet necessarily omits many items that are of financial value but that a company cannot record objectively. For example, the knowledge and skill of Intel employees in developing new computer chips are arguably the company's most significant assets. However, because Intel cannot reliably measure the value of its employees and other intangible assets (such as customer base, research superiority, and reputation), it does not recognize these items in the balance sheet. Similarly, many liabilities are reported in an "off-balance-sheet" manner, if at all.

The operating cycle is the average time between when a company acquires materials and supplies and when it receives cash for sales of the product (for which it acquired the materials and supplies).

The cycle operates from cash through inventory, production, receivables, and back to cash. When several operating cycles occur within one year (which is generally the case for service companies), a company uses the one-year period. If the operating cycle is more than one year, a company uses the longer period.

report form

The form of balance sheet with the Liabilities and Owner's Equity sections presented below the Assets section. -lists the sections one above the other, on the same page

Other Assets

The items included in the section "Other assets" vary widely in practice. Some include items such as long-term prepaid expenses, prepaid pension cost, and noncurrent receivables. Other items that might be included are assets in special funds, deferred income taxes, property held for sale, and restricted cash or securities. -limit this section to include only unusual items sufficiently different from assets included in specific categories

Purpose of the Statement of Cash Flows

The primary purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period (see Underlying Concepts).

Property, plant, and equipment are tangible long-lived assets used in the regular operations of the business.

These assets consist of physical property such as land, buildings, machinery, furniture, tools, and wasting resources (timberland, minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., timberlands or oil reserves) these assets.

Intangible assets lack physical substance and are not financial instruments (see the "Fair Values" section later in this chapter for the definition of a financial instrument).

They include patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists. A company writes off (amortizes) limited-life intangible assets over their useful lives.

The accountants at Rojas Textiles are preparing the balance sheet, but they are NOT using the account form or report form. What is the most likely reason for this?

They want to report working capital on the balance sheet.

Inventories

To present inventories properly, a company discloses the basis of valuation (e.g., lower-of-cost-or-net realizable value or lower-of-cost-or-market) and the cost flow assumption used

Receivables

amounts due from individuals and companies that are expected to be collected in cash -A company should clearly identify any expected loss due to uncollectibles, the amount and nature of any nontrade receivables, and any receivables used as collateral. Major categories of receivables should be shown in the balance sheet or the related notes. For receivables arising from unusual transactions (such as sale of property, or a loan to affiliates or employees), companies should separately classify these as long-term, unless collection is expected within one year.

contingency

an existing situation involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) that will ultimately be resolved when one or more future events occur or fail to occur

Current assets

are cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer.

Long-term liabilities

are obligations that a company does not reasonably expect to liquidate within the normal operating cycle.

Accounting policies

are the specific principles, bases, conventions, rules, and practices applied by a company in preparing and presenting financial information.

Elements of the Balance Sheet

assets, liabilities, equity

Ratio analysis

expresses the relationship among pieces of selected financial statement data, in a percentage, a rate, or a simple proportion.

Generally, if a company expects to convert an asset into cash or to use it to pay a current liability within a year or the operating cycle, whichever is longer, it classifies the asset as current.

however, is subject to interpretation. A company classifies an investment in common stock as either a current asset or a noncurrent asset depending on management's intent.

a company does not include long term assets as current assets unless

it intends to convert them to cash in the short-term

Free cash flow

net cash provided by operating activities after adjusting for capital expenditures and cash dividends paid

current cash debt coverage

net cash provided by operating activities/average current liabilities -The higher the current cash debt coverage, the less likely a company will have liquidity problems. For example, a ratio near 1:1 is good. It indicates that the company can meet all of its current obligations from internally generated cash flow.

cash debt coverage

net cash provided by operating activities/average total liabilities -The higher this ratio, the less likely the company will experience difficulty in meeting its obligations as they come due. It signals whether the company can pay its debts and survive if external sources of funds become limited or too expensive.

contra account

on a balance sheet reduces either an asset, liability, or owners' equity account

Where are liabilities placed on the balance sheet if a company plans to use the report form?

on the bottom of the first page

Companies classify cash receipts and cash payments during a period into three different activities in the statement of cash flows

operating, investing, and financing activities, defined as follows.

Companies classify long-term liabilities that mature within the current operating cycle as current liabilities if

payment of the obligation requires the use of current assets.

Frank is preparing his company's balance sheet. He has been asked to print a copy of the balance sheet so the entire document fits on one page. Frank should use the ________ form.

report

balance sheet

sometimes referred to as the statement of financial position, reports the assets, liabilities, and stockholders' equity of a business enterprise at a specific date

Current liabilities include

such items as trade and nontrade notes and accounts payable, advances received from customers, and current maturities of long-term debt. -no particular order

financial flexibility,

the "ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities

owners equity

the amount of the business that belongs to the owners minus any liabilities owed by the business

working capital

the difference between current assets and current liabilities

Liquidity

the ease with which an asset can be converted into cash -describes "the amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid."2 Creditors are interested in short-term liquidity ratios, such as the ratio of cash (or near cash) to short-term liabilities.

full disclosure principle

the information should be of sufficient importance to influence the judgment of an informed user

Compared to other methods of disclosure, a supporting schedule would be used to disclose

the most lengthy and detailed information.

retained earnings amount may be divided between the

unappropriated (the amount that is usually available for dividend distribution) and restricted (e.g., by bond indentures or other loan agreements) amounts

A parenthetical explanation should only be used to disclose information that is

very short.

To achieve this purpose, the statement of cash flows reports the following:

(1) the cash effects of operations during a period, (2) investing transactions, (3) financing transactions, and (4) the net increase or decrease in cash during the period.

adjunct account

, increases either an asset, liability, or owners' equity account.

companies should report separately:

1. Assets that differ in their type or expected function in the company's central operations or other activities. For example, IBM reports merchandise inventories separately from property, plant, and equipment. 2. Assets and liabilities with different implications for the company's financial flexibility. For example, a company that uses assets in its operations, like Walgreens, should report those assets separately from assets held for investment and assets subject to restrictions, such as leased equipment. 3. Assets and liabilities with different general liquidity characteristics. For example, Boeing Company reports cash separately from inventories.

Stockholders' Equity Section

1. Capital Stock. The par or stated value of the shares issued. 2. Additional Paid-in Capital. The excess of amounts paid in over the par or stated value. 3. Retained Earnings. The corporation's undistributed earnings. 4. Accumulated Other Comprehensive Income. The aggregate amount of the other comprehensive income items. 5. Treasury Stock. Generally, the cost of shares repurchased. 6. Noncontrolling Interest (Minority Interest). A portion of the equity of subsidiaries not wholly owned by the reporting company.

Preparing the Statement of Cash Flows Preparing the statement of cash flows from these sources involves four steps:

1. Determine the net cash provided by (or used in) operating activities. 2. Determine the net cash provided by (or used in) investing and financing activities. 3. Determine the change (increase or decrease) in cash during the period. 4. Reconcile the change in cash with the beginning and the ending cash balances.

Long-term investments, often referred to simply as investments, normally consist of one of four types:

1. Investments in securities, such as bonds, common stock, or long-term notes. 2. Investments in tangible fixed assets not currently used in operations, such as land held for speculation. 3. Investments set aside in special funds, such as a sinking fund, pension fund, or plant expansion fund. This includes the cash surrender value of life insurance. 4. Investments in nonconsolidated subsidiaries or affiliated companies.

Significant Noncash Activities Not all of a company's significant activities involve cash. Examples of significant noncash activities are:

1. Issuance of common stock to purchase assets. 2. Conversion of bonds into common stock. 3. Issuance of debt to purchase assets. 4. Exchanges of long-lived assets.

Generally, long-term liabilities are of three types:

1. Obligations arising from specific financing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable. 2. Obligations arising from the ordinary operations of the company, such as pension obligations and deferred income tax liabilities. 3. Obligations that depend on the occurrence or non-occurrence of one or more future events to confirm the amount payable, the payee, or the date payable, such as service or product warranties and other contingencies.

Current liabilities are the obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities. This concept includes:

1. Payables resulting from the acquisition of goods and services: accounts payable, wages payable, taxes payable, and so on. 2. Collections received in advance for the delivery of goods or performance of services, such as unearned rent revenue or unearned subscriptions revenue. 3. Other liabilities whose liquidation will take place within the operating cycle, such as the portion of long-term bonds to be paid in the current period or short-term obligations arising from the purchase of equipment.

1. Operating activities involve the cash effects of transactions that enter into the determination of net income. 2. Investing activities include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plant, and equipment.

3. Financing activities involve liability and owners' equity items. They include (a) obtaining resources from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed.

Prepaid Expenses

A company includes prepaid expenses in current assets if it will receive benefits (usually services) within one year or the operating cycle, whichever is longer.

In addition to the report and account forms of a balance sheet, which of the following is a less common way to present the balance sheet?

A format that uses current assets and current liabilities to calculate working capital.