Chapter 3
Balance Sheet and
Owners’ Interests
Chapter 3--Learning Objectives
1.
Interpret the conceptual basis for
the balance sheet and its
components: assets, liabilities, and
owners’ equity
Balance Sheet



A “snapshot”
Shows financial
position
of an enterprise
at a particular
point in time
Balance Sheet Elements



Assets
Assets
Liabilities
Owners’ Equity
Liabilities
& Equity
Accounting Equation
Assets = Liabilities & Owners’ Equity
Assets: Definition
Probable future economic benefits
obtained or controlled by a particular
entity as a result of past transactions
or events
Assets: Characteristics
 Probable
Future Benefit
will contribute to future cash flows
 Of
a Particular Entity
the business that will receive the benefit
 Transaction or
event giving rise to the
benefit has already occurred
Liabilities: Definition
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
Liabilities: Characteristics
 Present
duty or obligation that entails the
probable future transfer or use of assets
 Of a Particular Entity
the business that has the duty or obligation
 Transaction or
event giving rise to the
obligation has already occurred
Equity: Definition
The residual interest in the assets of the
entity that remains after deducting
liabilities
Equity = Assets - Liabilities
Net Assets
Equity: Characteristics
 Ownership Interest
stockholder, sole proprietor, or Partner
 Residual
Interest
increases or decreases by
operations
investments by owners
distributions to owners
Chapter 3--Learning Objectives
2. Recognize the various formats and
typical account classifications for
the balance sheet
XYZ Company
XYZ Company
Asset Classification

In order of Liquidity
Most
Liquid
Least Liquid
Current then Long-Term
Assets - Order of Classification





Current Assets
Investments
Property, Plant & Equipment
Intangible Assets
Other Assets
Chapter 3--Learning Objectives
3. Understand and identify the
elements of current assets and
current liabilities that comprise an
enterprise’s working capital
Working Capital
Current assets
Less:
Current liabilities
Equals: Working capital
Definition-Current Asset
Cash and other assets that can reasonably be
expected to be converted into cash or
consumed within the current operating cycle
or one year whichever is longer
Current Operating Cycle

Time between acquisition of inventory and
the conversion of the inventory back to cash
Typical Current Assets





Cash
Short-term investments
Accounts and notes receivables
Inventories
Prepaid expenses
IBM
30-Day
note
receivable
Cash



All cash on hand and on deposit
Readily available for current use
Measured in U.S. dollars
Short-Term Investments



Equity Securities
Debt Securities
Nonsecuritized Debt
Sometimes called
“Temporary Investments”
SFAS 115

Applies to
• Equity securities with readily determinable fair
values
• Debt securities
Measurement of Short-term
Investments in Equity Securities

Fair value
• Equity securities with readily determinable fair
values

Cost
• all other equity securities
Measurement of Short-Term
Investments in Debt

Cost
• If management plans to hold to maturity
• If nonsecuritized (e.g., notes receivable from
individuals)

Fair value
• All other debt securities
A/R and N/R

Carried at net realizable value
• The amount of cash expected to be collected
Accounts Receivable
minus Allowance for Doubtful Accounts
Net Realizable Value
Inventories


Measured at Lower-of-cost-or market
Examples:
•
•
•
•
•
Merchandise Inventory
Supplies
Work-in-Process
Raw Materials
Finished Goods
Prepaid Expenses


Measured at historical cost not consumed
Examples:
• Prepaid Insurance
• Prepaid Taxes
• Prepaid Rent
Liability Classifications


Current Liabilities
Long-term Liabilities
Current Liabilities


Obligations expected to be eliminated
through the use of existing current assets or
by the creation of other current liabilities
Typically, those due within one year
Typical current liabilities





Notes Payable
Accounts Payable
Accrued Expenses
Deferred Revenues
Current Maturities of Long-term Debt
Notes Payable


Trade and nontrade
Report at face value less any discount
Accounts Payable

From purchase of
• merchandise
• goods
• services

Typically reported at invoice amount
• ie, not discounted
Accrued Expenses


Typically not discounted
Examples:
• Salaries Payable
• Interest Payable
• Taxes Payable
Deferred Revenues


Obligated to perform services or deliver
goods for monies already received
Examples:
• Rent received in advance
• Magazine subscriptions received
• Deposits received
Chapter 3--Learning Objectives
4. Understand and identify the
noncurrent elements of a firm’s
balance sheet
Noncurrent Assets




Investments
Property, Plant & Equipment
Intangible Assets
Other
IBM
5 year
Bond
Patent
Investments





Special purpose funds (Sinking funds)
Long term investments in stock
Long term investments in bonds
Long term interest-bearing receivables
Land held for Speculation
Property, Plant & Equipment



Long-lived tangible assets used in
operations
Reported at cost less accumulated
depreciation
Examples:
•
•
•
•
Land
Buildings
Equipment
vehicles
Intangible Assets



Long-lived intangible operating assets
Reported at cost less accumulated
amortization
Examples:
•
•
•
•
Patents
Trademarks
Organization Costs
Goodwill
Other Assets


Deferred Tax Assets
Long-term prepaids
• rent deposits

Idle plant assets
Long-Term Liabilites


Reported at present value of future cash
payments.
Examples
• Bonds payable
• Leasehold obligations
• Deferred taxes
Chapter 3--Learning Objectives
5. Distinguish among the various
forms of entities, and interpret the
traditional presentation of
stockholders’ equity by source:
contributes capital and retained
earnings
Types of business entity



Proprietorships--Enterprises with a single
owner
Partnerships--Unincorporated businesses
with two or more owners
Corporations--Separate legal entities
established by applicable laws of
incorporation
Types of corporations


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
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Private companies
Stock companies
Publicly held
Listed companies
Unlisted (over-the-counter)
Closely held (nonpublic)
Nonstock companies
Public companies
Mutual companies
Advantages of the corporate form
of business



Potential to accumulate large amounts of
capital
Limited liability of owners
Relative ease of transferability of
ownership
Disadvantages of the corporate
form of business



Double taxation
Limited control by owners
Additional regulatory and reporting
requirements
Owner’s Equity




Paid-in Capital
Retained Earnings
Accumulated Other Comprehensive Income
Treasury Stock
Paid-in Capital



Common Stock
Preferred Stock
Additional Paid-in Capital
Common Stock & Preferred Stock


Par value or stated value
Additional paid-in capital
• Investments by owners in excess of par or
stated value
Retained Earnings

Accumulated earnings that have not been
distributed to owners.
Accumulated Other
Comprehensive Earnings


Adjustments to assets and liabilities that are
not reported in earnings
Examples:
• Unrealized gains/losses on investments in
securities under SFAS 115
• Translation Adjustment
• Unrealized losses from pension plans
Treasury Stock (at Cost)



The cost of acquiring stock back from
stockholders
This is stock that has been reacquired and
not retired
A contra equity
Chapter 3--Learning Objectives
6. Identify uses and limitations of
traditional balance sheets for
financial analysis
Analysis of Liquidity

Liquidity
•Ability to pay debts and continue
operations

Liquidity measures
•Working capital
•Current ratio
Current Ratio
Current Assets
Current Liabilities
The higher the current ratio
The greater the company’s
liquidity
Analysis of Solvency

Solvency
•Long-term financial status
•Ability to meet long-term as well as
current obligations

Solvency (risk) measures
•Debt ratio
•Leverage ratio
•Debt-to-equity ratio
*Debt ratio
=
Total Liabilities
Total Assets
Leverage ratio = Total Assets
Total Equity
*Debt-to-Equity =
Total Liabilities
Total Equity
*Higher ratios indicate more risk
Supplemental Disclosures



Segments
Subsequent Events
Contingencies
Subsequent events



Occur between the end of the reporting
period and the issue date for the financial
statements
Are not part of the normal operating
activities of the enterprise
Two types
1. Originating prior to subsequent period
and resolved during it
2. Originating during subsequent period
Subsequent events


Events originating prior to the statement
date and resolved during the subsequent
period
Requirement: adjust financial statements
Subsequent events


Events originating during the subsequent
period
Requirement: disclosure in the notes to the
statements
Contingencies

Gain Contingencies
• A possible future increase in Cash flows
• Generally not recognized in financial
statements

Loss Contingencies
• A possible future reduction in Cash flows
Accrue Loss Contingency

When both of the following conditions are
met
Probable
Can Reasonably Estimate Amount
Disclose Loss Contingency in
Footnotes

When either of the following conditions is
met
Probable,
but cannot reasonably estimate amount
Reasonably Possible
If remote - Don’t disclose
Exercise

Determine accounting treatment for
each of the following contingencies
Accounting Treatment?

Company is being sued, loss is probable,
but cannot estimate amount
Accrue
Footnotes
Nondisclosure
Accounting Treatment?

Company has warranty on products.
Experience indicates that warranty expenses
will probably be 5% of sales
Accrue
Footnotes
Nondisclosure
Accounting Treatment?

Company is being sued, loss is considered
remote
Accrue
Footnotes
Nondisclosure
Accounting Treatment?

Company is suing a competitor for patent
infringement. The company president
expects to win.
Accrue
Footnotes
Nondisclosure
Other disclosures


Significant accounting policies
Specific disclosures required by
pronouncements
• e.g., pension plan details
Balance sheet limitations
What does not appear ?
Human capital
Balance sheet limitations
What does not appear ?
Internally generated goodwill
Balance sheet limitations
What does not appear ?
Benefits from
research and development activities