StIce | StIce |Skousen
The Balance Sheet and Notes
to the Financial Statements
Chapter 3
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Learning Objectives
1. Describe the specific element of the
balance sheet (assets, liabilities, and
owners’ equity), and prepare a balance
sheet with assets and liabilities properly
classified into current and noncurrent
categories.
2. Identify the different formats used to
present balance sheet data.
3. Analyze a company’s performance and
financial position through the
computation of financial ratios.
Learning Objectives (cont.)
4. Recognize the importance of the
notes to the financial statements and
outlined the types of disclosures
made in the notes.
5. Understand the major limitations of
the balance sheet.
Problems to work using ThomsonNow:
Prob 37, 38, 40, 43
• Financial
Statements..\Coke
financials
The Balance Sheet
• Presents a listing of an organization’s
assets and liabilities at a certain time
point.
• The difference between assets and
liabilities is called equity.
• Represented by the basic accounting
equation:
Assets = Liabilities + Owners’ Equity
Elements of the Balance Sheet
compare to exhibit 3-2
Assets
Resources owned
or controlled by an
entity; costs
expected to provide
future economic
benefit.
• The primary
purpose of the
balance sheet is to
help forecast the
future.
Elements of the Balance Sheet
• “Obligation”
includes legal,
moral, social, and
implied
commitments.
• An obligation to
provide services is
also a liability.
• Assets and
liabilities arise
from past events.
Liability
• Claims of creditors
against the entity
resources; probable
future economic
resources
Elements of the Balance Sheet
• The amount of
total assets which
are claimed by the
owners
• The net assets of
an entity
• Is effected by
investment by
owners, net
income or loss,
distributions to
owners
Owner’s Equity
• The interest of the
ownership group in
an entity’s total
resources
How to Classify Items on the
Balance Sheet—exhib 3-3




Current (less than 1
year)
Noncurrent (more than
1 year)
Order of liquidity
Historical cost
Working capital = CA - CL
It is the liquid buffer available in meeting financial
demands and contingencies of the near future.
Current Assets
Cash and resources expected
to be converted to cash during
the entity’s normal operating
cycle or one year, whichever is
longer, are current assets.
Cash
Trading Securities
Accounts Receivables
Inventories
Prepaid Assets
Operating Cycle
Cash
Collections
Purchases
Inventories
Receivables
Sales
Noncurrent Assets
• Investments
• Property,
plant, and
equipment
• Intangible
Assets
• Deferred
income taxes
Current Liabilities
Generally,
if a liability
is expected
Current liabilities
are obligations
expectedto
to
be
paidusing
within
12 assets
months,
is
be paid
current
or byitcreating
classified
current as long as it is
other currentas
liabilities.
paid within the operating cycle.
Accounts and notes payable
Accrued expenses
Current portion of long-term
obligations
Unearned revenues
Callable Obligations
If the terms of the agreement for a
callable obligation is due on
demand or will become due on
demand within one year from the
balance sheet date, the obligation
should be classified as current.
Noncurrent Liabilities
• Current liabilities do not usually
include:
– Debts to be liquidated from a
noncurrent sinking fund.
• Sinking fund- cash and investment
securities that have been accumulated for
payment of a specific loan.
– Short-term obligations to be
refinanced.
Noncurrent Liabilities
• Long-term debt
• Long-term lease
obligations
• Deferred income
tax liability
• Pension
obligations
Noncurrent Liabilities
• Long-term debt is reported at its discounted
present value.
• When a note, bond issue, or a mortgage
becomes payable within a year, it should be
reclassified as a current liability.
• For a capital lease, the present value of the
future minimum payments is recorded as
long-term liability.
• Most large companies include deferred
taxes liabilities on the balance sheet.
Contingent Liabilities
• Presently “not real” liability but may
become a liability depending on the
occurrence of a future event.
Contingent Liabilities
• Past activities or circumstances may give
rise to possible future liabilities.
• Contingent liabilities- Potential obligations
that do not exist on the balance sheet date.
• Uncertainty as to whether future events will or
will not occur
• If “probable” a loss/liability will be recognized
• If only “possible” only disclosure is given
• If “remote” no action needs to be taken
• An estimated liability is a definite liability,
so it is not a contingent liability.
Estimated Liabilities
• Future certainty exists, but relative
amount and timing is questionable
• Examples:
–
–
–
–
Pensions
Warranties
Deferred taxes
Environmental cleanup
• Estimate $$$ amount should be
shown on the Balance Sheet
Owners’ Equity
•
•
Can also be called stockholders’ or
shareholders equity.
Generally divided into two parts:
1. Contributed capital also known as paidin-capital
2. Retained Earnings
Contributed Capital
• Two parts of contributed capital:
1. Capital Stock- the number of shares x the
par value.
a. Preferred stock- usually paid a fixed annual
cash dividend and have rights to their
investment in bankruptcy
b. Common stock- real owners of the corporation,
have voting power, but are last in line for
assets in bankruptcy
2. Additional paid-in capital- investment by
shareholders in excess of par value of
capital stock.
Retained Earnings
• Retained Earnings (RE)- the amount of
undistributed earnings of past
periods.
• RE Deficit- an excess of dividends and
losses over earnings results in a
negative retained earnings balance.
• Sometimes, RE is restricted and
unavailable for cash dividends.
Treasury Stock
X Corporation
Common Stock
Par $10
• Treasury Stock- when a company buys back
its own shares.
• Treasury shares can be retired, or they can
be retained and reissued later.
Other Equity
“Other Comprehensive Income”
The FASB requires
Unrealized gainsSome of the
companies to
Adjustments
and
lossesunrealized
on arising gains and
summarize
changes
from
the change
in the
available-for-sale
losses
from the
in owners’ equity
equity
foreign
fluctuations
in the
securities
areofshown
exclusive ofsubsidiaries
net value(as
as a separate equityof derivatives
measured
in
U.S. as part of
income and
are
reported
item.
These
are
dollars)by
resulting
from other
contributions
accumulated
shown
at their
changes
foreign
and distributions toin comprehensive
market
currencyvalue.
exchangeincome.
rates
owners.
are shown in the equity
section.
Format of the Balance Sheet
• Generally, assets and liabilities are
presented in their order of liquidity.
• Some industries with significant
investments in land and buildings will list
these items first on the balance sheet.
• Generally, a balance sheet is presented in
comparative form, including data from both
the current year and the previous year.
• Foreign balance sheets frequently list the
current assets and current liabilities
together. Compare exhibits 3-6 to 3-7
• Samples on my Homepage:
• Projected; with Ratios; Basic1; Basic2
Balance Sheet Analysis
•
Balance sheet information is
analyzed two ways:
1. Relationships between balance sheet
amounts
2. Relationships between balance sheet
and income statement amounts.
•
Financial ratios show the
relationships between financial
statement amounts.
Liquidity
•
•
Liquidity- the ability of a firm to
satisfy its short-term obligations.
Two common measures of liquidity:
1. Current ratio = Current Assets
Current Liabilities
2. Quick ratio = Quick Assets
Current Liabilities
What are the “quick assets?”
cash + investment securities + net
receivables
Liquidity Ratio Example
Cash
Net Accounts Receivable
Inventory Current Ratio
Current Assets
Current Liabilities
Current
Assets
$200
Current$100
Liabilities
$ 30
70
100
$200
100
= 2:1
Liquidity Ratio Example
Cash
Cash
Net
Accounts
Receivable
Net Accounts
Receivable
Quick Ratio
Inventory
Inventory
Current
Assets
Current Assets
Current
Liabilities
Current Liabilities
Quick
Assets
$100
Current$100
Liabilities
$$ 30
30
70
70
100
100
$200
$200
100
100
= 1:1
Leverage
What is Leverage?
•compares liabilities to assets to
determine the extent to which
borrowed funds are used to “leverage
the owners investments to increase
the business”
•referred to as the “debt ratio”
•shows the overall ability of the
company to repay its debts
Overall Leverage
Debt Ratio- total liabilities divided by
total assets.
Total Assets
$400
Total Liabilities
300
Total $300
Liabilities
$400
Total
Assets
= 75%
Efficiency
Asset Turnover- measures how
efficiently a company uses its assets
to generate sales.
Sales
$200
Total Assets
400
Other similar turnover
Sales
$200 ratios are—
= 0.50
accounts receivable,
inventory, fixed assets
Total
Assets
$400
Profitability
•
Two ratios that measure profitability:
1. Return on Assets--ROA
2. Return on Equity--ROI
Compares
Net
Income
to
some
Net Income
$ 40
measure
theon
size
of the
Total Assetsof
400
Return
Assets
Stockholders’ Equity
160
investment.
Net $40
Income
Total
Assets
$400
= 10.0%
Profitability
•
Two ratios that measure profitability:
1. Return on Assets
2. Return on Equity
Net Income
Total Assets
Return
Stockholders’ Equity
Net $40
Income
Total
Assets
$160
on Equity
= .25%
$ 40
400
160
Selected 2004 Ratios
Typical Notes to the Financial
Statements
• The financial statements do
not provide all of the
information desired by users.
Other useful information
includes:
Typical Notes to the Financial
Statements
• Summary of significant accounting policies,
i.e. methods related to depreciation,
inventory valuation, accounting changes,
and revenue recognition.
• Additional information to support summary
totals.
• Information that fails to meet recognition
criteria for statements, but is important for
users.
• Supplementary information required by the
FASB or SEC to adhere to full disclosure
Subsequent Events
occur after the Balance
Sheet date, but before the
financial statements
Subsequent Events
Balance Sheet Date Statements
Date
Issued
Financial Statement
Period
Subsequent
Period
Events in this period
may affect the reporting
of events in this period.
Subsequent Events
Balance Sheet Date Statements
Date
Issued
Financial Statement
Period
Subsequent
Period
Types of Events:
•Ones that materially affect one or
more financial statements.
•Ones that create a need for a
footnote.