CHAPTER 5
Balance Sheet and Statement of Cash Flows
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics
Questions
1.
Disclosure principles,
uses and limitations of
the balance sheet,
financial flexibility.
1, 2, 3, 4, 5,
6, 7, 10, 18,
20, 26, 29,
30, 31
2.
Classification of items
in the balance sheet
and other financial
statements.
11, 12, 13,
14, 15, 16,
17, 18, 19
3.
Preparation of balance 6, 9, 15, 16,
sheet; issues of
17, 29, 32
format, terminology,
and valuation.
4.
Statement of cash
flows.
21, 22, 23,
24, 25, 27,
28
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Brief
Exercises
1, 2, 3, 4, 5,
6, 7, 8, 9,
10, 11
12, 13, 14,
15, 16
Exercises
Problems
Concepts
for Analysis
6, 7
4, 5
1, 2, 3, 4,
5, 6, 7, 8,
9, 10
1, 2, 3
5, 6, 7, 11,
12, 17
1, 2, 3, 4,
5, 6, 7
3, 4
13, 14, 15,
16, 17, 18
6, 7
5
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5-1
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Brief
Exercises
Learning Objectives
Exercises
Problems
1.
Explain the uses and limitations of a
balance sheet.
2.
Identify the major classifications of the
balance sheet.
3.
Prepare a classified balance sheet using
the report and account formats.
4.
Indicate the purpose of the statement
of cash flows.
10
5.
Identify the content of the statement
of cash flows.
13
6.
Prepare a basic statement of cash flows.
12, 13, 14, 15
14, 15, 16,
17, 18
6, 7
7.
Understand the usefulness of the statement
of cash flows.
16
15, 16, 18
6, 7
8.
Determine which balance sheet information
requires supplemental disclosure.
9.
Describe the major disclosure techniques
for the balance sheet.
5-2
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6, 7
1, 2, 3, 4, 6,
8, 9
1, 2, 3, 4, 5,
6, 7, 8, 9,
10, 11
1, 2, 3, 4, 5,
6, 7, 9, 10,
11, 12, 17
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1, 2, 3, 4,
5, 6, 7
4
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ASSIGNMENT CHARACTERISTICS TABLE
Level of
Difficulty
Time
(minutes)
Balance sheet classifications.
Classification of balance sheet accounts.
Classification of balance sheet accounts.
Preparation of a classified balance sheet.
Preparation of a corrected balance sheet.
Corrections of a balance sheet.
Current assets section of the balance sheet.
Current vs. long-term liabilities.
Current assets and current liabilities.
Current liabilities.
Balance sheet preparation.
Preparation of a balance sheet.
Statement of cash flows—classifications.
Preparation of a statement of cash flows.
Preparation of a statement of cash flows.
Preparation of a statement of cash flows.
Preparation of a statement of cash flows and a
balance sheet.
Preparation of a statement of cash flows, analysis.
Simple
Simple
Simple
Simple
Simple
Complex
Moderate
Moderate
Complex
Moderate
Moderate
Moderate
Moderate
Moderate
Moderate
Moderate
Moderate
15–20
15–20
15–20
30–35
30–35
30–35
15–20
10–15
30–35
15–20
25–30
30–35
15–20
25–35
25–35
25–35
30–35
Moderate
25–35
Preparation of a classified balance sheet, periodic
inventory.
Balance sheet preparation.
Balance sheet adjustment and preparation.
Preparation of a corrected balance sheet.
Balance sheet adjustment and preparation.
Preparation of a statement of cash flows and
a balance sheet.
Preparation of a statement of cash flows and
a balance sheet.
Moderate
30–35
Moderate
Moderate
Complex
Complex
Complex
35–40
40–45
40–45
40–50
35–45
Complex
40–50
Reporting for financial effects of varied transactions.
Identifying balance sheet deficiencies.
Critique of balance sheet format and content.
Presentation of property, plant, and equipment.
Cash flow analysis.
Moderate
Moderate
Simple
Simple
Complex
25–30
20–25
25–30
20–25
40–50
Item
Description
E5-1
E5-2
E5-3
E5-4
E5-5
E5-6
E5-7
E5-8
E5-9
E5-10
E5-11
E5-12
E5-13
E5-14
E5-15
E5-16
E5-17
E5-18
P5-1
P5-2
P5-3
P5-4
P5-5
P5-6
P5-7
CA5-1
CA5-2
CA5-3
CA5-4
CA5-5
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5-3
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
6.
7.
8.
9.
*10.
*11.
5-4
Explain the uses and limitations of a balance sheet.
Identify the major classifications of the balance sheet.
Prepare a classified balance sheet using the report and account formats.
Indicate the purpose of the statement of cash flows.
Identify the content of the statement of cash flows.
Prepare a basic statement of cash flows.
Understand the usefulness of the statement of cash flows.
Determine which balance sheet information requires supplemental disclosure.
Describe the major disclosure techniques for the balance sheet.
Identify the major types of financial ratios and what they measure.
Compare the accounting procedures related to the balance sheet under GAAP and
IFRS.
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CHAPTER REVIEW
*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
1. Chapter 5 presents a detailed discussion of the concepts and techniques that underlie the
preparation and analysis of the balance sheet. Along with the mechanics of preparation,
acceptable disclosure requirements are examined and illustrated. A brief introduction to
the statement of cash flows is also presented. This explanation serves as a foundation for
the more comprehensive discussion of this subject presented in Chapter 23. At the end of
Chapter 5, a multi-page illustration of the financial statements and accompanying notes
of a corporation are presented. This illustration may be referred to throughout the study of
intermediate accounting as it includes information relevant to many of the topics discussed
in subsequent chapters.
Usefulness of the Balance Sheet
2. (L.O. 1) For many years financial statement users generally considered the income
statement to be superior to the balance sheet as a basis for judging the economic wellbeing of an enterprise. However, the balance sheet can be a very useful financial statement.
If a balance sheet is examined carefully, users can gain a considerable amount of information
used to assess liquidity, solvency and financial flexibility. Liquidity is generally related
to 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. Solvency refers to the ability of an
enterprise to pay its debts as they mature. Financial flexibility is the ability of an enterprise
to take effective action to alter the amounts and timing of cash flow so that it can respond
to unexpected needs and opportunities.
Limitations of the Balance Sheet
3. Criticism of the balance sheet has revolved around the limitations of the information
presented therein. These limitations include:
(a) Failure to reflect current value information.
(b) The extensive use of judgment and estimates.
(c) Failure to include items of financial value that cannot be recorded objectively.
4. The problem with current value information concerns the reliability of such information.
The estimation process involved in developing current-value type information causes
a concern about the objectivity of the resulting financial information. The use of estimates
is extensive in the development of balance sheet data. These estimates are required by
generally accepted accounting principles, but reflect a limitation of the balance sheet. The
limitation concerns the fact that the estimates are only as good as the understanding and
objectivity of the person(s) making the estimates. The final limitation of the balance sheet
concerns the fact that some significant assets of the entity are not recorded. Items such
as human resources (employee workforce), managerial skills, customer base, and reputation
are not recorded because such assets are difficult to quantify.
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5-5
Classification in the Balance Sheet
5. (S.O. 2) The major classifications used in the balance sheet are assets, liabilities, and
equity.
To provide the financial statement reader with additional information, these major
classifications are divided into several subclassifications. Assets are further classified as
current or noncurrent, with the noncurrent divided among long-term investments;
property, plant, and equipment; intangible assets; and other assets. Liabilities are classified
as current or noncurrent. Owners’ equity includes capital stock, additional paid-in capital,
and retained earnings.
Assets. Probable future economic benefits obtained or controlled by a particular
entity as a result of past transactions or events.
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.
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.
Current Assets
6. 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. Current
assets are presented in the balance sheet in the order of their liquidity and normally include
cash and cash equivalents, short-term investments, receivables, inventories, and prepaid
expenses.There are some exceptions to a literal interpretation of the current asset
definition. These exceptions involve prepaid expenses, investments in common stock, and
the subsequent years’ depreciation of fixed assets. These exceptions are recognized in the
accounting process and are understood by most financial statement users.
Reporting Current Assets
7.
5-6
Any restrictions on the general availability of cash or any commitments on its probable
disposition must be disclosed. Short-term investments are usually categorized as heldto-maturity, trading, or available-for-sale. Any anticipated loss due to uncollectibles, the
amount and nature of any nontrade receivables, and any receivables designated as
collateral should be clearly identified. For a proper presentation of inventories, the basis
of valuation (i.e., lower of cost or market) and the method of pricing (FIFO or LIFO) should
be disclosed. A company includes prepaid expenses in current assets if it will receive
benefits within one year or the operating cycle, whichever is longer.
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Long-Term Investments
8. Items classified as long-term investments in the assets section of the balance sheet
normally are one of four types. These include:
a. Investments in securities, such as common stock, bonds, or long-term notes.
b. Investments in tangible fixed assets not currently used in operations.
c. Investments set aside in special funds (sinking, pension, plant expansion, etc.) and
the cash surrender value of life insurance.
d. Investments in nonconsolidated subsidiaries or affiliated companies.
Long-term investments are rather permanent in nature as they are not normally disposed
of for a long period of time. They are shown in the balance sheet below current assets in
a separate section called Investments.
Property, Plant and Equipment
9. Property, plant and equipment are properties of a durable nature that are used in the
regular operations of the enterprise. Examples include land, land improvements, buildings,
machinery, furniture, tools, and wasting resources. With the exception of land, these assets
are either depreciable or depletable.
Intangible Assets
10. Intangible assets lack physical substance. However, their benefit lies in the rights they
convey to the holder. Examples include patents, copyrights, franchises, goodwill, trademarks,
trade names, and secret processes.
11. Limited-life intangible assets are amortized over their useful lives. Indefinite-life intangibles (such as goodwill) are not amortized but, instead, are assessed at least annually
for impairment.
Other Assets
12. Many companies include an “Other Assets” classification in the balance sheet after
Intangible Assets. This section includes a wide variety of items that do not appear to fall
clearly into one of the other classifications. Some of the more common items included in
this section are: deferred charges, noncurrent receivables, prepaid pension costs,
deferred income taxes, and advances to subsidiaries.
Current Liabilities
13. Current liabilities are the obligations that are reasonably expected to be liquidated either
through the use of current assets or the creation of other current liabilities. Items normally
shown in the current liabilities section of the balance sheet include notes and accounts
payable, advances received from customers, current maturities of long-term debt, taxes
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5-7
payable, and accrued liabilities. Obligations due to be paid during the next year may be
excluded from the current liability section if the item is expected to be refinanced through
long-term debt or the item will be paid out of noncurrent assets.
14. Working capital is the excess of current assets over current liabilities. This concept,
sometimes referred to as net working capital, represents the net amount of a company’s
relatively liquid resources.
Long-Term Liabilities
15. Long-term liabilities are obligations whose settlement dates extend beyond the normal
operating cycle or one year, whichever is longer. Examples include bonds payable, notes
payable, lease obligations, and pension obligations. Generally, the disclosure requirements for long-term liabilities are quite substantial as a result of various covenants and
restrictions included for the protection of the lenders. Long-term liabilities that mature within
the current operating cycle are classified as current liabilities if their liquidation requires
the use of current assets. Long-term liabilities generally fall into one of the three following
categories:
a. Obligations arising from specific financing situations, such as the issuance of bonds,
long-term lease obligations, and long-term notes payable.
b. Obligations arising from the ordinary operations of the company such as pension
obligations and deferred income tax liabilities.
c. Obligations that depend on the occurrence or non-occurrence of one or more future
events to confirm the amount payable, or the date payable, such as product warranties
and other contingencies.
Owners’ Equity
16. The owners’ equity section of the balance sheet includes information related to capital stock,
additional paid-in capital, and retained earnings. Preparation of the owners’ equity section
should be approached with caution because of the various restrictions imposed by state
corporation laws, liability agreements, and voluntary actions of the board of directors.
Balance Sheet Format
17. (L.O. 3) The account format of a classified balance sheet lists assets by sections on the
left side and liabilities and stockholders’ equity by sections on the right side. The report
format lists liabilities and stockholders’ equity directly below assets on the same page.
Statement of Cash Flows
18. (L.O. 4) 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.
The statement of cash flows answers three questions:
a.
5-8
Where did the cash come from during the period?
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b.
What was the cash used for during the period?
c.
What was the change in the cash balance during the period?
19. (L.O. 5) In accomplishing its purpose, the statement focuses attention on three different
activities related to cash flows.
a. Operating activities involve the cash effects of transactions that enter into determination
of net income.
b. Investing activities include making and collecting loans and acquiring and disposing
of debt and equity investments and property, plant, and equipment.
c. Financing activities involve liability and owners’ equity items and include (1) obtaining
resources from owners and providing them with a return on their investment and
(2) borrowing money from creditors and repaying the amounts borrowed.
The basic format of the statement of cash flows is shown below.
Statement of Cash Flows
Cash flows from operating activities ..................
Cash flows from investing activities ...................
Cash flows from financing activities ...................
Net increase (decrease) in cash ........................
Cash at beginning of year..................................
Cash at end of year ...........................................
$XXX
XXX
XXX
XXX
XXX
$XXX
20. The statement of cash flow’s value is that it helps users evaluate liquidity, solvency, and
financial flexibility.
21. (L.O. 6) The information to prepare the statement of cash flows comes from three sources:
(a) comparative balance sheets, (b) the current income statement, and (c) selected
transaction data. Preparation of the statement of cash flows involves the following steps.
a. Determine the cash provided by operations.
b. Determine the cash provided by or used in investing and financing activities.
c. Determine the change (increase or decrease) in cash during the period.
d. Reconcile the change in cash with the beginning and the ending cash balances.
The information included in this chapter on the preparation of the statement of cash flows
provides a basic introduction to the concepts involved. A complete and detailed presentation
of the statement of cash flows is found in Chapter 23 of the text.
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5-9
Usefulness of the Statement of Cash Flows
22. (L.O. 7) Creditors look for answers to the following questions in the company’s cash flow
statement:
a. How successful is the company in generating net cash provided by operating activities?
b. What are the trends in net cash flow provided by operating activities over time?
c. What are the major reasons for the positive or negative net cash provided by operating
activities?
Financial Liquidity
23. The current cash debt coverage ratio indicates whether the company can pay off its
current liabilities from its operations in a given year.
Net Cash Provided by Operating Activities
Average Current Liabilities
=
Current Cash Debt Coverage Ratio
Financial Flexibility
24. The cash debt coverage ratio measures a company’s ability to repay its liabilities from
net cash provided by operating activities.
Net Cash Provided by Operating Activities
Average Total Liabilities
=
Cash Debt Coverage Ratio
Free Cash Flow
25. Free cash flow is the amount of discretionary cash flow a company has for purchasing
additional investments, retiring its debt, purchasing treasury stock, or simply adding to its
liquidity.
Net Cash Provided by
Operating Activities
–
Capital Expenditures
–
Dividends
= Free Cash Flow
Supplemental Disclosures
26. (S.O. 8) Supplemental disclosures related to contingencies, accounting policies,
contractual situations, and fair values provide for elaboration or qualification of items
listed in the balance sheet.
27. A contingency is defined as an existing situation involving uncertainty as to a possible
gain (gain contingency) or loss (loss contingency) that will ultimately be resolved when
one or more future events occur or fail to occur. In short, they are uncertain occurrences
that may have a material effect on financial position.
5-10
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28. The methods used to value assets and allocate costs vary considerably among balance
sheet accounts. To help users of the financial statements understand and evaluate financial
statement components and their relationships, these valuation methods are normally
disclosed in a separate Summary of Significant Accounting Policies preceding the
financial statement notes. In addition to contingencies and valuation methods, any contractual
situations of significance should be disclosed. These items include pension obligations,
lease contracts, stock options, etc.
Fair Values
29. Financial instruments are defined as cash, an ownership interest, or a contractual right to
receive, or an obligation to deliver cash or another financial instrument. Companies are to
follow a fair value hierarchy that provides insight into how to determine fair values. Level 1
(the most reliable) measures are based on observable inputs, such as market price for
identical assets or liabilities. Level 2 (less reliable) measures are based on market-based
inputs other than those included in Level 1, such as those based on market prices for
similar assets or liabilities. Level 3 (least reliable) measures are based on unobservable
inputs, such as a company’s own data or assumptions. In addition, companies must
provide significant additional disclosure related to Level 3 measurements.
Techniques of Disclosure
30. (S.O. 9) Effective communication of the information required to be disclosed in financial
statements is an important consideration. Accountants have developed certain methods
that have proven useful in disclosing pertinent information. The methods are parenthetical
explanations, notes, cross reference and contra items, and supporting schedules.
Numerous examples of the techniques of disclosure are presented in the text.
Terminology
31. The balance sheet should contain descriptive labels that readers will generally
understand and clearly interpret. The profession has recommended that companies use
the work ‘reserve’ only to describe an appropriation of retained earnings. In addition, the
profession has recommended that the use of the work ‘surplus’ be discontinued in the
equity section of the balance sheet.
*Ratio Analysis
*32. (S.O. 10) Appendix 5A Ratio Analysis. Demonstrates various ratios used to analyze
financial performance.
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5-11
LECTURE OUTLINE
It should be emphasized that this chapter is a review chapter and the intent is to provide
an overview for topics that will be dealt with in greater detail in later chapters.
As a review of Chapters 4 and 5, we recommend that you encourage students to examine
a set of actual financial statements and the accompanying notes. Appendix 5-B in the text
contains specimen financial statements for The Procter & Gamble Company.
The material in the chapter can be covered in two class sessions. The first session can be
used for lecture on the concepts covered in the chapter. Most students should have had
previous exposure to these concepts. The first session can also be used for reviewing some of
the shorter problem material such as Exercises 5-1 through 5-4 and Cases 5-1 through 5-3.
You may wish to call upon students for their answers to the items in these exercises and
cases. Most items are straightforward, but some of them will stimulate class discussion and
highlight areas of misunderstanding.
The second class session can be used for final review and for going over the longer problem
material. This material allows students to apply chapter concepts by critiquing and preparing
financial statements.
TEACHING TIP
As a comprehensive review of Chapters 4 and 5, use Illustration 5-7 to discuss the specimen financial statements of The Procter & Gamble Company that appear in Appendix 5-B in
the textbook. Reproduce and distribute Illustration 5-7. The exercise can be used as either
an in-class assignment or as a homework assignment.
A. (L.O. 1) Usefulness of the Balance Sheet.
1.
Provides information about entity’s assets, liabilities, and equity.
2.
Aids in assessing risk and predicting future cash flows.
3.
Evaluation of liquidity, solvency, and financial flexibility.
B. Limitations of the Balance Sheet.
1.
Fair value is not reflected.
2.
Estimates and judgments must be utilized:
5-12
a.
in determining the collectibility of receivables.
b.
in determining the useful lives of long-term assets.
c.
in assessing the number of inventory returns.
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3.
Omits many items that are of financial value to the business.
a.
Assets such as the value of a company’s knowledge, skills, human resources, and
research and development are not reported.
b.
Some liabilities or commitments such as leases and certain contractual arrangements are reported in an “off-balance-sheet” manner, or not at all.
C. (L.O. 2) Classifications in the Balance Sheet.
TEACHING TIP
Illustration 5-1 can be used in a discussion of the major classifications and subclassifications in
the balance sheet.
1.
Assets.
2.
Liabilities.
3.
Equity.
D. Major Subclassifications in the Balance Sheet.
1.
Current assets.
TEACHING TIP
Illustration 5-2 can be used in discussing the relationship among current assets, current
liabilities, working capital and the operating cycle.
a.
Definition: 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. (Point
out the distinction between the operating cycle and the accounting cycle.)
b.
Point out some conceptual weaknesses in the classification of current assets:
(1) Prepaid expenses will neither be turned into cash nor used to pay a current
liability. Discuss the justification for including them in current assets.
(2) Consumption of plant assets during the current period: conceptually, the
current depreciation and amortization charges should be classified as current
assets, analogous to the “currently maturing portion of long-term debt.”
c.
Items included in the current assets section are presented in the order of liquidity.
(1) Cash. Any cash restricted for purposes other than current obligations is
excluded from current assets.
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(2) Short-term investments. Investments in debt securities are classified as
either trading, available-for-sale, or held-to-maturity, while investments in
equity securities are classified as either trading or available-for-sale. Trading
and available-for-sale securities are reported at fair value, while held-tomaturity securities are reported at amortized cost. Trading securities are
classified as current, while available-for-sale and held-to-maturity are
classified as current or noncurrent based on circumstances.
(3) Receivables. The amounts of expected uncollectibles, nontrade receivables,
and accounts pledged or discounted must be disclosed.
(4) Inventories. The basis of valuation (e.g., cost or the lower-of-cost-or-market),
pricing method (e.g., FIFO, LIFO, etc.), and stage of completion of manufactured
inventories should be disclosed.
(5) Prepaid expenses. Included as current assets if a company will receive
benefits within one year or the operating cycle, whichever is longer.
2.
3.
4.
5-14
Long-term investments. The management intends is to hold these investments for an
extended period of time.
a.
Investments in securities: bonds, common stock, long-term notes.
b.
Investments in tangible fixed assets not currently used in operations: land held for
speculation.
c.
Investments set aside in special funds: sinking funds, pension funds, plant
expansion funds, and cash surrender value of life insurance.
d.
Investments in nonconsolidated subsidiaries or affiliated companies.
Property, plant, and equipment. Tangible long-lived assets such as land, buildings,
machinery, furniture, and “wasting resources” (timberland, minerals) used in operations.
a.
Most assets in this category are either depreciable (e.g., buildings) or consumable
(e.g., timberlands). Land is not depreciated. However, land improvements are
depreciated.
b.
The basis of valuation (e.g., historical cost), any liens against the property, and
accumulated depreciation or depletion must be disclosed.
c.
In practice, a detailed classification of property, plant, and equipment is disclosed
in a supplementary schedule rather than on the face of the balance sheet.
Intangible assets. Assets that lack physical substance, which are not financial
instruments, but represent significant economic resources.
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5.
6.
7.
a.
Examples include patents, franchises, copyrights, goodwill, trademarks, trade names,
and customer lists.
b.
Limited-life intangible assets are amortized over their useful lives and reported
net of the accumulated amortization.
c.
Indefinite-life intangible assets, such as goodwill, are not amortized but are
assessed periodically for impairment.
Other assets. A special classification for unusual items that cannot be included in one
of the other asset categories.
a.
Examples include long-term prepaid expenses, noncurrent receivables, and
deferred income taxes.
b.
This section should include only unusual items sufficiently different from assets
included in specific categories.
Point out that the classification of assets depends on both the nature of the item and
the use to which it is put. For example:
a.
Land used as factory site—classify as property, plant, and equipment.
b.
Land held for speculation—classify as long-term investment.
Current liabilities.
a.
Definition: Obligations that are reasonably expected to be liquidated through the
use of current assets or the creation of other current liabilities.
b.
Examples:
(1) Payables resulting from the acquisition of goods and services: accounts
payable, wages payable, taxes payable.
(2) Collections received in advance for the delivery of goods or performance of
services: unearned rent revenue, unearned subscriptions revenue.
(3) Other liabilities whose liquidation will take place within the operating cycle:
long-term bonds to be paid in the current period, short-term obligations
arising from purchase of equipment.
c.
Companies most commonly list notes payable, accounts payable, or short-term
debt as the first item.
d.
Some liabilities that will be paid within a year are reported as long-term liabilities.
This occurs when the company expects to
(1) refinance the debt through another long-term issue.
(2) retire the debt out of noncurrent assets.
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e.
Working capital represents the net amount of a company’s relatively liquid
resources.
(1) Working capital = total current assets – total current liabilities
8.
Long-term liabilities.
a.
Definition: Obligations that are not reasonably expected to be liquidated within the
normal operating cycle.
b.
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.
c.
Three types:
(1) Obligations arising from specific financing situations: issuance of bonds, longterm lease obligations, and long-term notes payable.
(2) Obligations arising from 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, or the payee, or the date payable
(e.g., product warranties, or other contingencies.)
9.
d.
Any premium or discount on bonds is disclosed separately as an addition to or
subtraction from the bonds payable.
e.
Supplementary information that is usually disclosed in separate schedules or notes
to financial statements includes the existence of debt covenants and restrictions
and the terms of the debt, such as maturity dates, interest rates, and amounts of
any securities pledged to support the debt.
Owners’ equity.
a.
Stockholders’ equity of corporations.
(1) Capital stock. The par or stated value of the shares issued.
(a) The number of authorized, issued, and outstanding shares and the par
value amounts must be disclosed.
(b) Treasury stock is shown as a reduction of stockholders’ equity.
(2) Additional paid-in capital. The excess of amounts paid, in over the par or
stated or par value.
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(3) Retained earnings. The undistributed earnings of the corporation. Separate
disclosure is made of unappropriated (available for dividends) and appropriated
(restricted) retained earnings.
TEACHING TIP
Use the illustrations on text pages 226 and 227 to discuss stockholders’ equity sections.
E. (L. O. 3) Balance Sheet Format.
1.
Report and account formats.
a.
Account form: lists assets on the left side and liabilities and stockholders’ equity
on the right side.
b.
Report form: lists assets first, followed by liabilities and stockholders’ equity
immediately below.
F. Statement of Cash Flows.
TEACHING TIP
Use Illustrations 5-3 and 5-4 to give an overview of the statement of cash flows.
1.
2.
(L.O. 4) Purpose of the statement.
a.
The primary purpose of a statement of cash flows is to provide relevant
information about the cash receipts and cash payments of a company during a
period.
b.
It reports the operating, investing, and financing transactions of the business.
The statement is useful because it provides answers to the following important
questions:
a.
Where did the cash come from during the period?
b.
What was the cash used for during the period?
c.
What was the change in the cash balance during the period?
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3.
4.
5.
(L.O. 5) Content of the statement of cash flows.
a.
Operating activities. Involve the cash effects of transactions that enter in the
determination of net income.
b.
Investing activities. Involve making and collecting loans, and acquiring and
disposing of debt and equity investments and property, plant, and equipment.
c.
Financing activities. Include obtaining capital from owners and providing them a
return on their investment, and borrowing money from creditors and repaying the
amounts borrowed.
Preparing a basic statement of cash flows.
a.
Determine the cash provided by operations.
b.
Determine the cash provided by or used in investing and financing activities.
c.
Determine the change (increase or decrease) in cash during the period.
d.
Reconcile the change in cash with the beginning and the ending cash balances.
Investing activities and financing activities.
Investing Activities
Financing Activities
Cash from selling property, plant & equipment
Issuance of equity securities
Cash from the sale of debt/equity investments
Issuance of debt
Collection of loans
Payment of dividends
Purchase of property, plant, & equipment
Redemption of debt
Purchase of debt/equity investments
Reacquisition of capital stock
Loans to other entities
6.
Significant noncash activities.
a.
All significant noncash financing and investing activities are reported in either a
separate schedule at the bottom of the statement or in separate notes to the
financial statements.
b.
Examples of transactions that must be disclosed:
(1) Issuance of common stock to purchase assets.
(2) conversion of bonds to common stock.
(3) Issuance of debt to purchase assets.
(4) Exchanges of long-lived assets.
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G. (L.O. 7) Usefulness of the statement of cash flows.
1.
Information on the statement is used to evaluate liquidity, solvency, and financial
flexibility.
2.
Analysis of net cash provided by operating activities includes:
a.
Current cash debt coverage. Used to determine whether a company can pay off
its current liabilities from its operating activities. It evaluates financial liquidity.
b.
Cash debt coverage. Used to determine whether a company can repay its liabilities from its operating activities. It evaluates financial flexibility.
c.
Free cash flow. Used to determine the discretionary cash flow a company has to
purchase additional investments, retire its debt, purchase treasury stock, or add to
its liquidity.
TEACHING TIP
Illustration 5-5 provides the formulas for analyzing net cash provided by operating activities.
H. (L.O. 8) Supplemental disclosures.
1.
2.
3.
Contingencies—Material events that have an uncertain outcome.
a.
Gain contingencies—may be related to tax operating loss carryforwards or
company litigation against another party.
b.
Loss contingencies—may relate to litigation, environmental issues, possible tax
assessments, or government investigations.
Accounting policies.
a.
GAAP recommends disclosure for all significant accounting principles and methods
that involve selection from among alternatives or those that are peculiar to a given
industry.
b.
This disclosure is usually given in a separate Summary of Significant
Accounting Policies preceding the notes to the financial statements or as the
initial note.
c.
Companies must also disclose information about the nature of their operations, the
use of estimates in preparing financial statements, and vulnerabilities due to certain
concentrations.
Contractual situations. Companies should disclose the essential provisions of lease
contracts, pension obligations, and stock option plans in the notes to the financial
statements.
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4.
Fair values.
a.
Financial Instruments are defined as cash, an ownership interest, or a
contractual right to receive or obligation to deliver cash or another financial
instrument.
b.
Can be either assets or liabilities.
c.
Both the carrying value and the estimated fair value of financial instruments must
be disclosed in the financial statements.
I. (L.O. 9) Techniques of Disclosure.
1.
Parenthetical explanations (Example: “net of tax” calculations in Chapter 4).
2.
Notes (Example: accounting policies and contingencies).
3.
Cross-reference and contra items (Example: bond discounts).
4.
Supporting schedules (Example: lease disclosures).
5.
Terminology.
a.
The term “reserve” should be used only to describe an appropriation of retained
earnings.
b.
Use of the term “surplus” is discouraged.
*J. (L.O. 10) APPENDIX 5-A. Ratio Analysis.
1.
Used to express the relationships between selected financial statement data.
2.
Can be classified as:
a.
Liquidity ratios. Measures the company’s short-term ability to pay its maturing
obligations.
b.
Activity ratios. Measures how effective a company uses its assets.
c.
Profitability ratios. Measures the success or failure of a company.
d.
Coverage ratios. Measures the degree of protection for long-term creditors and
investors.
TEACHING TIP
Use Illustration 5-6 to discuss the specific ratios included in each classification.
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*K. APPENDIX 5-B. Specimen financial statements.
TEACHING TIP
Use the questions in Illustrations 5-7 and 5-8 to review the financial statements of The
Procter & Gamble Company.
*L. (L.O. 11) IFRS Insights
1.
As in GAAP, the balance sheet and the statement of cash flows are required
statements for IFRS. In addition, the content and presentation of an IFRS balance
sheet and cash flow statement are similar to those used for GAAP. In general, the
disclosure requirements related to the balance sheet and the statement of cash flows
are much more extensive and detailed in the United States. IAS 1, “Presentation of
Financial Statements,” provides the overall IFRS requirements for balance sheet
information. IAS 7, “Cash Flow Statements,” provides the overall IFRS requirements for
cash flow information. IFRS insights on the statement of cash flows are presented in
Chapter 23.
2.
Relevant Facts
a. Similarities
(1) Both IFRS and GAAP allow the use of title “balance sheet” or “statement of
financial position.” IFRS recommends but does not require the use of the title
“statement of financial position” rather than balance sheet.
(2) Both IFRS and GAAP require disclosures about (1) accounting policies
followed, (2) judgments that management has made in the process of
applying the entity’s accounting policies, and (3) the key assumptions and
estimation uncertainty that could result in a material adjustment to the
carrying amounts of assets and liabilities within the next financial year.
Comparative prior period information must be presented and financial
statements must be prepared annually.
(3) IFRS and GAAP require presentation of noncontrolling interests in the equity
section of the balance sheet.
b. Differences
(1) IFRS requires a classified statement of financial position except in very limited
situations. IFRS follows the same guidelines as this textbook for
distinguishing between current and noncurrent assets and liabilities. However
under GAAP, public companies must follow SEC regulations, which require
specific line items. In addition, specific GAAP mandates certain forms of
reporting this information.
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(2) Under IFRS, current assets are usually listed in the reverse order of liquidity.
For example, under GAAP cash is listed first, but under IFRS it is listed last.
(3) IFRS has many differences in terminology that you will notice in this textbook.
(4) Use of the term “reserve” is discouraged in GAAP, but there is no such
prohibition in IFRS.
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ILLUSTRATION 5-1
BALANCE SHEET CLASSIFICATIONS
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ILLUSTRATION 5-2
CURRENT ASSET CLASSIFICATION
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ILLUSTRATION 5-3
STATEMENT OF CASH FLOWS
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ILLUSTRATION 5-4
STATEMENT OF CASH FLOWS (INDIRECT METHOD)
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ILLUSTRATION 5-5
FORMULAS FOR ANALYZING NET CASH PROVIDED
BY OPERATING ACTIVITIES
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ILLUSTRATION 5-6
RATIOS
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ILLUSTRATION 5-7
QUESTIONS COVERING THE FINANCIAL STATEMENTS
OF THE PROCTER & GAMBLE COMPANY
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ILLUSTRATION 5-7 (continued)
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ILLUSTRATION 5-8
ANSWERS TO QUESTIONS ABOUT THE FINANCIAL
STATEMENTS OF THE PROCTER & GAMBLE COMPANY
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ILLUSTRATION 5-8 (continued)
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ILLUSTRATION 5-8 (continued)
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