UNDERSTANDING FINANCIAL
STATEMENTS
THE BALANCE SHEET
What is a BALANCE SHEET?
A “statement of financial condition”
On a particular date (a “snapshot”)
OBJECTIVES:
– a fundamental understanding of accounts
described on a balance sheet
– a feel for the relationship of each account to
the financial statements as a whole
The Basic Equation
ASSETS = LIABLITIES +
STOCKHOLDERS’ EQUITY
– Where assets are economic resources (the
left side of the equation)
– Where liabilities and equities are claims to
those resources (the right side of the
equation)
Another look: Basic Equation
ASSETS are what the firm owns
LIABILITIES are what the firm owes to
outsiders
EQUITIES are what the firm owes to
insiders
Therefore: Assets = Liabilities +
Stockholders’ Equity represents equality
between resources and claims to
resources
Classify each account
Salary Expense
Sales
Land
Accounts Payable
Accounts Rec
Equipment
Cash
Notes payable
Prepaid insurance
Supplies
Supply Expense
Accumulated
Depreciation
Depreciation expense
Common Stock
Retained Earnings
Patent
Some General Parameters
Financial statements are often
CONSOLIDATED
Balance sheet is DATED (end of
accounting period): calendar year or fiscal
year or interim period
Some COMPARATIVE DATA is presented
(e.g. balances for end of previous year
shown on balance sheet)
ASSETS (the “left” side)
Generally presented in order of liquidity
Current Assets -- defined as cash or
assets expected to be converted to cash
within one year or operating cycle,
whichever is longer
– operating cycle is time required to
purchase/manufacture the inventory, sell it
and collect the cash
ASSETS (continued)
Noncurrent Assets -- defined as assets
expected to be converted to cash after the
completion of one year or one operating
cycle, whichever is longer
A Look at Current Assets
Cash
Marketable Securities (short-term)
Accounts Receivable
Notes Receivable (short-term)
Inventory
Prepaid Expenses
...and Noncurrent Assets?
Long-term Investments
Property, Plant and Equipment
Intangible Assets
“Other” Assets -- the “catchall” category
Okay, let’s go one-by-one:
First we’ll look at typical current assets
Then we’ll turn our attention to typical
noncurrent assets
– Later we’ll look at liabilities and equities
(the “right” side of the equation)
Objective is to understand what the
category is and what the numbers mean
(sometimes this is easy, then
sometimes….)
Cash
The most liquid of assets
Generally includes currency, coin,
balances in checking and other demand or
“near demand” accounts
Marketable Securities
May include t-bills, CDs, stocks, bonds
Debt vs. equity securities
Classifications
– Held to maturity
– Trading securities
– Securities available for sale
Investment Category
Held to
maturity
Trading
Avail for Sale
Type
Debt
Debt & Eq
Debt & Eq
Revenue
Interest
Int & Div
Int & Div
Value on BS
Amortized
Cost
Market Value Market Value
Recog Unreal G/L on
IS?
No
Yes
No (unrealized
g/l in equity sec)
Cash Flow
Investing
Operating
Investing
Description
Intent and
ability to
hold until
maturity
Traded
within 3
month
Not in other
categories
The following events apply to the investment activities of Duffy Company.
1. Duffy purchased $25,000 of debt securities on January 1, 20X1.
2. Duffy sold $5,000 of the debt securities purchased in Event No. 1 for
$6,000.
3. Duffy received $2,000 of interest income on December 31, 20X1.
4. The market value of the remaining debt securities was $20,500 on
December 31, 20X1.
Required:
Record the effects of each event in a financial statements model assuming
the debt securities are classified as (1) held-to-maturity, (2) trading, or (3)
available-for-sale. When recording amounts in the cash flow column,
indicate whether the item is an operating activity (OA), investing activity
(IA) or a financing activity (FA).
Solution
Click here to download solution
Solution is labeled Demo Problem 8-1
You probably want to go ahead and print it
off because there is another solution on
the page for a problem on inventory.
Accounts Receivable
Arise from credit-sale transactions
Reported on the balance sheet at NET
REALIZABLE VALUE
– Accounts Receivable
$$$
– Less Allowance for Doubtful Accounts $$$
– Net Accounts Receivable
$$$
A Word on the “Allowance…”
Management must estimate the dollar
amount of accounts they expect to be
uncollectible
Affects balance sheet valuation AND bad
debt expense on income statement
Can be important in assessing earnings
quality -- changes should be analyzed
Analyzing receivables - Kodak
Trade receivables
Miscellaneous rec
Total (net of allowances of 89 and
136)
2000
1999
$2,245 $2,140
408
397
$2,653 $2,537
2000
Receivables (from balance sheet)
Allowance (Note 20
1999
$2,653 $2,537
89
136
Total Receivables
$2,742 $2,673
Sales (from income statement
13,994 14,089
Inventory
Consist of items held for sale or used in
manufacture of goods for sale
Merchandising Company
– one type of inventory (finished goods)
Manufacturing Company
– three types of inventories (raw materials,
work-in-process, finished goods)
Often a BIG dollar item -- often firm’s
major revenue producer
Inventory Issues
Major concern with method of valuation
(which MUST be DISCLOSED)
– FIFO (first-in, first-out)
– LIFO (last-in, first-out)
– Weighted Average Cost
Effect of inflation on CGS and NI
Illustration of Fifo/Lifo
1/1 BI 200@$3
3/1 Purchase 300@$3.50
6/1 Purchase 400 @ $4.00
11/1 purchase 100 @ $4.50
$600
1050
1600
450
Total CGAS (1000 units)
$3700
Sold 700 units
Had 1000 units available for sale, sold 700, so must have 300 left in
ending inventory. For FIFO, the ending inventory will be the last 300
units in (since first units were sold). For LIFO, the ending inventory will
be the first 300 units in (since the last ones in were sold)
FIFO
LIFO
Weighted
Average
Cost of Goods
Available for
Sale
$3700
$3700
$3700
Less Ending
Inventory
100@4.50
200@4.00
$1250
200@3.00
100@3.50
$950
$3700/1000 =
$3.70 per unit
300@3.70
$1110
Cost of Goods
Sold
$2450
200@3.00
300@3.50
200@4.00
$2650
100@4.50
400@4.00
200@3.50
$2590
700@3.70
More Inventory Issues
Inventory valuations SIGNIFICANTLY
affects BOTH the balance sheet and the
income statement
Disclosure of inventory cost flow
assumption found on face of balance
sheet or (more commonly) in notes
Inventory reported on balance sheet at
LOWER OF COST OR MARKET
Pleasant Grove Electronics carries four different types of
calculators. The quantities, costs, and market values are
shown below. Based on this information, determine the
amount of the required lower of cost or market (LCM) writedown assuming Pleasant Grove determines LCM on an
individual basis. (solution is 8-4 on page you printed)
Type
Quantity
Unit Cost Unit Mkt
A
100
$12
B
550
8
6
C
710
25
24
D
240
20
22
15
Kodak - inventories
(in millions)
2000
1999
Sales (from
income statement
$13,994
$14,089
1,718
1,519
Inventories
Prepaid Expenses
Represent expenses paid in advance -included in current assets if they expire
within one year or operating cycle
Usually not a material item
Present few or no reporting or valuation
issues
ON TO NONCURRENT ASSETS…….
Property, Plant & Equipment
(PP&E)
Often called “fixed assets”
Represent major resource commitments
which benefit a firm for more than one
year
Recorded at HISTORICAL cost; cost
allocated over asset’s useful life through
DEPRECIATION (exception: land is not
depreciated)
PP&E Issues
PP&E is reported on balance sheet at
historical cost less accumulated
depreciation to date
Depreciation process involves
ESTIMATES
Depreciated cost reported on balance
sheet is reliable; one might seriously
question how relevant it is...
More PP&E Issues
Firm has CHOICE of depreciation method:
accelerated, straight-line
Comparison among firms can be made difficult
with different methods and different estimates
Use of EBITDA
Proportion of fixed assets (PP&E) in a firm’s
asset structure determined by nature of the
business
Depreciation Methods
Straight Line (78%)
Cost – Salvage Value
Useful Life
Depreciation Expense (IS)
Accumulated Depreciation (BS)
Units of Production Method is similar but uses
units of activity as denominator
Example
Jones Brothers purchases new equipment for $50,000.
It is estimated to have a useful life of 5 years and a
salvage value of $10,000. How much is the annual
depreciation?
50,000-10,000 = $40,000/5 = $8,000 per year
5 years
Year 1 $8,000 dep exp, $42,000 net asset value
Year 2 $8,000 dep exp, $34,000 net asset value…..
Year 5 $8,000 dep exp, $10,000 net asset value
Depreciation Methods
Accelerated Methods (4%)
Declining balance rate
Considered accelerated method
Accelerated method
Straight line
Depreciation
Expense
Year
Intangible Assets
Resources with expected future economic
benefits but lacking a physical substance
Some examples are patents, copyrights,
goodwill
Goodwill can be material if firm is heavily
involved in acquisition activity
Amortization for cost recovery
– Shorter of economic life, legal life or 40 years
Patent – right to manufacture,
sell, lease invention
Copyright – protection against
illegal reproductions of
creator’s written works,
designs, and literary
productions
Franchise – contract between
2 parties granting franchisee
certain rights and privileges
(life defined by contract_
Trademark – symbol, design,
logo
(unlimited legal life)
Legal life is 17 years
from date patent is
grated
Legal life is life of
creator plus 50 years
If lump sum made,
rather than periodic
payments, capitalize
and amortize
If internally
developed, no cost
assigned
Goodwill
Prior to FASB 142
– Pooling (no goodwill recognized)
– Purchase (goodwill shown and amortized/40 yr)
1/1/02 FAS 142
– Pooling eliminated
– Goodwill evaluated annually to determine if it
has lost value
Intel
Natural Resources
Standing timber and underground deposits
of oil, gas, and minerals
– Physically extracted in operations
– Replaceable only by an act of nature
Total cost minus salvage
Total estimated units
Depletion expense (IS)
Accumulated depletion (BS)
Other Assets
Can include multitude of other
noncurrent items, for example
– property held for sale
– long-term investments
– start-up costs in connection with a new
business
– cash surrender value of life insurance
policies
– long term advance payments
NOW WHAT????
NOW, HOW ABOUT THE OTHER
(“RIGHT”) SIDE OF THE BALANCE
SHEET…….
Let’s take a look at liabilities and equities
(the “claims” to the assets we just looked
at…)
LIABILITIES & EQUITIES
REPRESENT CLAIMS TO ASSETS
LIABILITIES: Creditor Claims
EQUITIES:
Owner Claims
Constitute the “right” side of equation
LIABILITIES
May be CURRENT or LONG-TERM -same criteria of “one-year or operating
cycle, whichever is longer” applies here as
well
Represent claims by creditors of the firm
A Look at Current Liabilities
Accounts Payable
Short-term Notes Payable
Accrued Liabilities
Unearned Revenues (Deferred Credits)
Current Maturity Portion of Long-term
Debt
Deferred Taxes (some, not all or even
most…)
…and Long-Term Liabilities?
Notes or Mortgages Payables
Bonds Payable
Pension and Lease Obligations
Deferred Taxes (most)
Warranty Obligations
Other Long-Term Debt
Okay, let’s look at some of
these…..starting with Current Liabilities
Accounts Payable
Usually defined as obligations arising from
purchases of merchandise for resale or of
raw materials
Few valuation or reporting issues
Significant changes from period to period
often result from changes in sales volume
Short-Term Notes Payable
Promissory notes due within a year (or
operating cycle if more appropriate)
Usually are interest-bearing
Usually reported at face value because of
short-term nature
Accrued Liabilities
Result from accrual basis of accounting
Represent expenses that have been
INCURRED and thus ACCRUED, but have
NOT BEEN PAID in cash
Examples are Interest Payable and Wages
Payable
In this case, cash flow follows expense
recognition
Unearned Revenue
Sometimes called “deferred credits”
Results from a prepayment received in
advance for services or products
Under accrual accounting, revenue is
recognized when EARNED, not when
received in cash -- in this case, cash flow
precedes revenue recognition
Current Maturities - LT Debt
Represent principal payments on debt that
are due within one year
Confirms the old adage that nothing is
long-term forever -- eventually it has to be
paid as a current item!
Now, how about those items that are
STILL LONG-TERM LIABILITIES
Notes or Mortgages Payable
Represent any mortgages or notes
payable that do not have any principal
repayment requirements during the
coming year
Bonds Payable
Once again, represent items that do not
have any principal payment requirements
within the next year
Bond characteristics
Secured v. unsecured
Registered v. bearer
Coupon bonds
Term v. serial
Callable
Convertible
Junk bonds
Bond with stock warrants
Pension & Lease Obligations
Generally reported at the present value of
expected future cash outflows
Can represent MAJOR liabilities for many
firms and have a significant impact on the
balance sheet
Defined benefit vs. defined contribution
Warranty Obligations
Represent liability of a firm to repair or
replace merchandise that it sells
Some estimating is necessary, but if the
firm regularly sells items with a warranty
attached, the liability must be disclosed...
Postemployment Liabilities
Medical bills for retired employees
Reported as liability on balance sheet
Deferred Income Taxes
Financial Statement Income DOES
NOT NECESSARILY EQUAL Taxable
Income!!!
Taxes paid are based on TAXABLE
income as defined by the IRS; tax
expense reported on income statement
is based on FINANCIAL statement
income
Deferred Income Taxes (cont.)
Deferred Income Taxes result from
TIMING (temporary) differences in taxable
and financial statement income
Examples are many:
– depreciation (major difference for many)
– pension expense
– installment sale accounting
– others
More on Deferred Taxes
Classification may be current or long-term
depending on the asset or liability
underlying the temporary difference
Most are found in the long-term liability
section
Other Long-Term Debt
Once again, a “catch-all” category for long
term obligations not reported elsewhere
Keeping debt off the books
– Enron
-------------------------NOW, WHAT ABOUT OWNER
CLAIMS???
Stockholders’ Equity
Represent claims to assets by OWNERS,
i.e. stockholders
Is often referred to as a RESIDUAL; this
flows from a restatement of the basic
equation:
ASSETS - LIABILITIES = EQUITIES
More on Stockholders’ Equity
Usually consists of STOCK ACCOUNTS
AND ADDITIONAL PAID-IN CAPITAL and
RETAINED EARNINGS -- may have other
equity accounts
Additional paid-in capital is the difference
between par value and what was received
for the stock
Stock
Par, no par and stated value
Market, book, liquidation, redemption
value
Authorized, issued, outstanding
Common vs. preferred
Cumulative vs. non-cumulative
Convertible vs. non-convertible
Callable
Stock vs. Bond
Bond is debt, stock is ownership
Bonds mature, stock doesn’t
Most bonds require periodic interest
payments. Dividends payable only when
declared
Bond interest deductible for both book and
tax, dividends are not.
Retained Earnings
In simplest terms, represents the
cumulative undistributed earnings of the
business since its inception
Represent funds the company has chosen
to “retain” and reinvest in the business
RETAINED EARNINGS DOES NOT
REPRESENT A PILE OF CASH!!!!!!!
“Other” Equity Accounts?
Can include such things as unrealized
holding gains/losses on investments,
treasury stock, foreign currency translation
effects
So, What Have We Learned?
Balance Sheet is a “snapshot”
Assets = Liabilities & Equities
Can “walk” through a balance sheet and
(a) understand what the account titles
mean and (b) have at least the beginnings
of an understanding of where some of the
numbers come from
Caution Flags
Reductions in the allowance for doubtful accounts when
accounts receivable are increasing
Sales and receivables growing at substantially different
rates or moving in opposite directions
Sales and inventories growing at substantially different
rates or moving in opposite directions.
Categories of inventories moving in opposite directions
Excessive use of “other” for material, unexplained items
Write-down in value of goodwill
Borrowings growing faster than assets being financed;
debt rising when assets are decreasing
Caution Flags cont’d
Financial statement notes obscure rather than
enlighten
Changes in and additions to financial statement
notes require PhD in accounting and
measurement by yardstick rather than ruler
Substantial amount of income from
unpredictable and possibly unsustainable
sources, such as pension plans
Extensive use of stock options for employee
compensation
So What’s Next?
Everything you want or need to know
cannot be found on the balance sheet
Next we will look at the income
statement and try to understand what
it’s trying to tell us
Also, we need to become aware there
are many important relationships
between income statement and
balance sheet items……..
Valedico!