The Balance Sheet and Financial Disclosures- Chapter 3

Current Assets

include cash and other assets that are reasonably expected to be converted to cash or consumed within the coming year, or within the normal operating cycle of the business if that's longer than one year.

Inventories

include goods awaiting sale (finished goods), goods in the course of production (work in process) and goods to be consumed directly or indirectly in production (raw materials). Inventory for a wholesale or retail company consists only of finished goods, but the inventory of a manufacturer will include all 3 types of goods.

Other Assets

includes long-term prepaid expenses, called deferred charges, and any non-current asset not failing in one of the other classifications.

Times interest earned ratio

indicates the margin of safety provided to creditors

Favorable Financial leverage

means earning a return on borrowed funds that exceeds the cost of borrowing the funds

Current Liabilities

obligations that are expected to be satisfied through the use of current assets or the creation of other current liabilities, So this classification includes all liabilities that are expected to be satisfied within one year or the operating cycle, whichever is longer.

Long Term Liabilities

obligations that will not be satisfied in the next year or operating cycle, whichever is longer, do not require the use of current liabilities for payment. Examples- long-term notes, bonds, pension obligations, and lease obligations. Details about the in information surrounding the payment terms, interest rates, and other details needed to asses the impact of these obligations on future cash flows and long-term solvency are reported in a disclosure note.

Liabilities

obligations to other entities

Accounts payable

obligations to suppliers of merchandise or of services purchased on open account, with payment usually due in 30 to 60 days

Financial Ratios

often are used in risk analysis to investigate a company's liquidity and long term solvency

Liquidity

period of time before an asset is converted to cash or until a liability is paid. useful in assessing a company's ability to pay its current obligations.

Assets

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

Financing Ratios

provide some indication provide some indication of the riskiness of a company with regard to is ability to pay its long-term debts. Two common financing ratios are (1) the debt to equity ratio and (2) the times interest earned ratio Debt to Equity ratio = Total Liabilities/ Shareholders Equity Time interest earned ratio = Net income + interest expense + income taxes/Interest Expense

Solvency

provides information about financial flexibility-the ability of a company to alter cash flows in order to take advantage of unexpected investment opportunities and needs. For example, the higher the percentage of a company's liabilities to is equity, the more difficult it typically will be to borrow additional funds either to take advantage of a promising investment opportunity or meet obligations.

Liquidity

refers to the readiness of assets to be converted to cash, by comparing a company's liquid assets with its short-term obligations., two common measures of liquidity are (1) the current ratio and (2) the acid-test ratio (or quick ratio) Current ratio = Current assets/Current Liabilities Acid Test Ratio (or quick ratio)= Quick Assets/Current Liabilities

operational risk

relates more to how adept a company is at withstanding various events and circumstances that might impair its ability to earn profits.

Current Ratio

relationship between current assets and current liabilities, computed by dividing current assets by current liabilities, a current ratio of 2 indicates that the company has twice as many assets as liabilities.

Accrued liabilities

represent obligations created when expenses have been incurred but will not be paid until a subsequent reporting period, examples include salaries payable, accrued interest payable, and accrued taxes payable. long term notes, loans, mortgages, and bonds payable usually are reclassified and reported as current liabilities as they become payable within the next year.

Prepaid expenses

represents an asset recorded when an expense is paid in advance, creating benefits beyond the current period. If rent on an office building were prepaid for one year, then the entire prepayment is classified as a current asset. If rent were prepaid for a period extending beyond the coming year, a portion of the prepayment is classified as an other asset, a non-current asset.

Management Discussion and Analysis

required on each annual report of a public company, provides a biased by informed perspective of a company's operations, liquidity, and capital resources.

Shareholders Equity

residual amount derived by subtracting liabilities from assets, sometimes referred to as net assets.

Accounts Receivable

result from the sale of goods or services on credit, often referred to as trade receivables, because they arise in the course of a company's normal trade. Non-trade receivables are supported by a formal agreement or note that specifies payment terms they are called notes receivable. Usually due within 30 to 60 days.

Long-Term Solvency

riskiness of a company with regard to the amount of liabilities in its capital structure, the risk to an investor or creditor increases as the percentage of liabilities, relative to equity, increases.

Relationship Between Risk and Profitability

shareholders receive no return on their investments until after all creditor claims are paid. Therefore, the higher the debt to equity ratio, the higher the risk to shareholders.

Subsequent Event

significant development that occurs after a company's fiscal year end but before the financial statements are issued or available to be issued.

Other Than an Unqualified Opinion

some audits need to issue other than an unqualified opinino due to exceptions such as (a) nonconformity with generally accepted accounting principles, (b) inadequate disclosures, and (c) a limitation or restriction of the scope of teh exmaination. In these situations an audition will issue a (an) Qualified Opinion Adverse opinion Disclaimer

Unearned revenues

sometimes called deferred revenues, represent cash received from a customer for goods or services to be provided in a future period.

Shareholders Equity

stockholders equity, equity for a corporation arises primarily from 2 sources; (1) amounts invested by shareholders in the corporation, and (2) amounts earned by the corporation ( on behalf of its shareholders). These are reported as (1) paid-in capital and (2) retained earnings. Retained earnings represents the accumulated net income earned since the inception of the corporation and not yet paid to its shareholders as dividends.

Operating Cycle

typical manufacturing company refers to the period of time necessary to convert cash to raw materials, raw materials to a finished product, the finished product to receivables, and then finally receivables. For most businesses, this cycle will be less than one year. In these situations, the one year convention is used to classify both assets and liabilities. where a company has no clearly defined operating cycle, a one year convention is used.

Qualified Opinion

This contains an exception to the standard unqualified opinion but not of sufficient seriousness to invalidate the financial statements as a whole

Adverse opinion

This is necessary when the exceptions (a) and (b) above are so serious that a qualified opinion is not justified. Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report.

Disclosure Notes

Typically, the first disclosure note consists of a summary of significant accounting policies that discloses the choices the company makes, for example if management chose, accelerated or straight line deprecation, whether they used FIFO, LIFO, or average cost to measure inventories, etc.

Most Common Current Liabilities

accounts payable, notes payable (short term borrowings), unearned revenues, accrued liabilities, and the currently maturing portion of long-term debt.

Comparative Financial Statements

allow financial statement users to compare year to year finacial position, results of operations, and cash flows.

default risk

analysis of a company's ability to pay obligations when they come due.

Liabilities

are 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.

Notes payble

are usually written promises to pay cash at some future date (I.O.U.s). Unlike accounts payable, notes usually require the payment of explicit interest in addition to the original obligation amount.. Notes maturing in the next year or operating cycle, whichever is longer, will be classified as current liabilities.

Investments

assets that are not used directly in the operations of the business, investments in equity and debt securities of other corporations, land held for speculation, non-current receivables, and cash set aside for special purposes (such as for future plant expansion). These assets are classified as non-current because management does not intend to convert the assets into cash in the next year (or the operating cycle if that's longer).

Intangible Assets

assets used in the operations of a business have no physical substance. These represent the ownership of an exclusive right to something such as a product, a process or a name. Patents, copy-rights, and franchises are examples. Reported in the balance sheet net of accumulated amortization. Some companies include intangible assets as part of property,plant, and equipment, while others report them either in a separate intangible asset classification or as other non-current assets.

Illegal Acts

bribes, kickbacks, illegal contributions to political candidates, and other violations of the law.

Equity (or not assets)

called shareholders' equity or stockholders' equity for a corporation, is the residual interest in the assets of an entity that remains after deducting liabilities.

Debt to Equity Ratio

compares resources provided by creditors with resources provided by owners. calculated by dividing total liabilities (current and noncurrent) by total shareholders equity (including retained earnings) other things equal, the higher the ratio, the higher the risk.

Proxy Statement

contains disclosures on compensation to directors and executives

Balance Sheet Values

describes many of the resources a company has available for generating future cash flows, assets and liability are grouped according to common characteristics.

Working Capital

difference between current assets and current liabilties

Irregularities

distinction between errors and irregularities is that errors are unintentional while irregularities are intentional distortions of financial statements.

Balance Sheet Limitation

does not portray the market value of the entity as a going concern, nor its liquidation value. Many assets like land and buildings are measured at their historical costs rather than their fair values.

Acid test ratio

excludes inventories and prepaid items from current assets before dividing by current liabilities. the numerator then consists of cash, short- term investments, and accounts receivable, the "quick assets"

Horizontal Analysis

expressing each item as a percentage of that same item in the financial statements of another year (base amount) in order to more easily see year to year changes

Balance Sheet Summary

Even though the balance sheet does not directly measure the market value of the entity, it provides valuable information that can be used to help judge market value.

Vertical Analysis

Expressing each item as a percentage of an appropriate corresponding total, or base amount but within the same year.

Financial Disclosures

Financial Statement disclosures are provided (1) by including additional information, often parenthetically, on the face of the statement following a financial statement item and (2) in disclosure notes that often include supporting schedules. Common examples of disclosures included on the face of the balance sheet are the allowance for uncollectible accounts and information about common stock.

Balance Sheet Order

Individual current assets are listed in the order of their liquidity, nearness to cash, Cash is listed first, (Cash includes cash on hand, in banks that is available for use in the operations of the business and such items as bank drafts, cashier's checks, and money orders). Cash equivalents frequently include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. These are highly liquid investments that can be quickly converted into cash.

Unqualified Opinion with Explanatory paragraph

Lack of consistency due to a change in accounting principle such that comparability is affected even though the auditor concurs with the desirability of the change Uncertainty as to the ultimate resolution of a contingency for which a loss is material in amount but not necessarily probable or probable but not estimable. Emphasis of a matter concerning the financial statements that does not affect the existence of an unqualified opinion but relates to a significant even such as a related party transaction.

Management Responsibilities

Management prepares and is responsible for the financial statements and other information in the annual report. Management's responsibilities section avows the responsibility of management for the company's financial statements and internal control system.

Disclosure Notes

Must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions, but many notes are fashioned to suit the disclosure needs of the particular reporting enterprise. Actually, any explanation that contributes to investors' and creditors' understanding of the results of operations, financial position, and cash flows of the company should be included.

Shareholders Equity

Net income, less dividends- reported as retained earnings. Companies paid in capital is represented by common stock and additional paid-in capital less treasury stock, which collectively represent cash invested by shareholders in exchange for ownership interest. Information about the number of shares the company has authorized and how many shares have been issued and are outstanding also must be disclosed.

Noteworthy Events and Transactions

Some transactions and events occur only occasionally, but when they do occur are potentially important to evaluating a company's financial statements. In this category are related party transactions, errors and irregularities, and illegal acts. The more frequent of these is related-party transactions.

Balance Sheet

Sometimes referred to as statement of financial position, reports a company's financial position on a particular date.

Property, Plant, and Equipment

Tangible, long-lived, and used in the operations of the business. Property, plant, and equipment, along with intangible assets, often are the primary revenue-generating assets of the business.

Short-Term Investments

Temporary investments, short term marketable securities. investments in stock and debt securities of other corporations are included as short-term investments if the company has the ability and intent to sell those securities within the next 12 months or operating cycle, whichever is longer.

Disclaimer

An auditor will disclaim an opinion for item (c) above such that insufficient information has been gathered to express an opinion.

Auditors Opinion of Going Concern

Auditor is required to evaluate the company's ability to continue for a reasonable time as a going concern. If the auditor determines there is significant doubt, an explanation of the potential problem must be included in the auditor's report.

Auditors Report

Auditors examine financial statements and the internal control procedures designed to control the content of those statements.

Balance Sheet

Represents an organized array of assets, liabilities, and shareholders' equity at a point in time.

Balance Sheet Classifications

Usefulness of the balance sheet is enhanced when assets and liabilities are grouped according to common characteristics. The broad distinction made in the balance sheet is the current verses non-current classification of both assets and liabilities.

Unqualified Opinion

Usually the case, auditors are satisified that the financial statements, "present fairly", the financial position, results of operations, and cash flows are in conformity with accounting principles generally accepted in the United States of America.