Chapter 2 The Balance Sheet Copyright 2013 Pearson

The Balance Sheet • Also called the statement of condition or the statement of financial position • Shows the financial condition of a company on a particular date • Summarizes what the firms owns and what the firm owes to outsiders and to internal owners Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -2

Financial Condition • Assets are what the firm owns. • Liabilities are what the firm owes to outsiders. • Stockholders’ equity is what the firm owes to internal owners. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -3

Financial Condition Consolidation • Parent company owns more than 50% of voting stock. •

Financial Condition Balance Sheet Date • The date the balance sheet is prepared • Could be the end of the calendar year, fiscal year, quarter, etc. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -5

Financial Condition Comparative Data • SEC requires two-year audited balance sheets. • Provides a reference point for determining changes in financial position Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -6

Financial Condition Common-Size Balance Sheet • Expresses each item on the balance sheet as a percentage of total assets • • Reveals the composition of assets Form of vertical ratio analysis Useful for evaluating trends within a firm Allows for making industry comparisons Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -7

Financial Condition Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -8

Assets Segregated according to how they are utilized • Current Assets • Property, Plant,

Assets Current Assets • Expected to be converted to cash within one year or one operating cycle • Continually used up and replenished Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -10

Assets Current Assets • Operating cycle § Time required to purchase or manufacture inventory, sell the product, and collect the cash • Working capital § Also called net working capital § Current assets less current liabilities Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -11

Assets Current Assets • • • Cash and cash equivalents Marketable securities Accounts receivable

Assets Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -13

Assets Current Assets – Cash and Cash Equivalents • Cash awaiting deposit • Cash in a bank account • Short-term investments that can be converted to cash within three months Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -14

Assets Current Assets – Marketable Securities • Short-term investments that can be converted to cash within a year • Three categories § Held to maturity § Trading securities § Securities available for sale Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -15

Assets Current Assets – Accounts Receivable • Customer balances outstanding on credit sales • Net realizable value – actual amount of account less an allowance for doubtful accounts Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -16

Assets Current Assets – Accounts Receivable • Allowance for doubtful accounts § Affects balance sheet valuation § Important in assessing earnings quality § Should reflect volume of credit sales, past experiences with customers, customer base, credit policies, collections practices, and economic conditions Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -17

Assets The allowance account for Sage Inc. represents approximately 5% of accounts receivable: Copyright

Assets Current Assets – Accounts Receivable • There should be a consistent relationship between the rate of change in sales, accounts receivable, and the allowance for doubtful accounts. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -19

Assets Sage Inc. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2

Assets To analyze the preceding information, consider the following: • Are all three accounts changing in the same directions and at consistent rates of change? • If the direction and rates of change are not consistent, what are possible explanations for these differences? • If there is not a normal relationship between the growth rates, what are possible reasons for the abnormal pattern? Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -21

Assets For Sage Inc. , • Sales, accounts receivable, and the allowance for doubtful accounts have all increased. • Allowance account has increased appropriately in relation to accounts receivable. • Sales have grown at a much greater rate. § More sales in cash have probably been collected. § Sage will probably experience fewer defaults. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -22

Assets Current Assets – Accounts Receivable • Additional information helpful to the analysis of accounts receivable and the allowance account is provided in the schedule of “Valuation and Qualifying Accounts. ” § Additions Charged to Costs and Expenses § Deductions Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -23

Assets Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -24

Assets • “Additions Charged to Costs and Expenses” is the amount estimated and recorded as bad debt expense each year on the income statement. • “Deductions” is the actual amount the firm has written off as accounts receivable they no longer expect to recover. • Analyst should use this schedule to assess the probability that the firm is intentionally over- or underestimating the allowance account. • Sage Inc. appears to estimate an expense fairly close to the actual amount written of each year. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -25

Assets Current Assets – Inventories • Items held for sale • Items used in the manufacture of products that will be sold • Major revenue producer for most companies Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -26

Assets Current Assets – Inventories • Retail companies § • • Finished goods Manufacturing companies § Raw materials § Work-in-process § Finished goods Service –oriented companies § Little to no inventory Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -27

Assets Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -28

Assets Current Assets – Inventories • Inventory Accounting Methods § Method used has considerable impact on financial position and operating results. § Valuation is based on an assumption regarding the flow of goods, not the actual order in which products are sold. § Cost flow assumption is made in order to match the cost of products sold to the revenue generated. § Disclosure of inventory cost flow assumption is found in the notes. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -29

Assets Current Assets – Inventories • Inventory Accounting Methods § First in, first out (FIFO) § Last in, first out (LIFO) § Average cost Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -30

Assets Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -31

Assets Example – A new company in its first year of operations purchases five products for sale in the order and at the prices shown. The company sells three of these items at the end of the year. Item Purchase Price #1 $5 #2 $7 #3 $8 #4 $9 #5 $11 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -32

Assets Cost flow assumptions Resulting effect on the income statement and balance sheet Copyright

Assets Current Assets – Inventories • Inventory Accounting Methods § During a period of inflation, the LIFO method typically produces • • • the highest cost of goods sold expense • cost of goods sold values at current cost of inventory items the lowest ending valuation of inventory undervalued inventories on the balance sheet Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -34

Assets Current Assets – Inventories • Inventory Accounting Methods § During a period of inflation, the FIFO method typically produces • • • the lowest cost of goods sold expense • cost of goods sold values below the current cost of inventory items the highest ending valuation of inventory values on the balance sheet that are at current cost Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -35

Assets Current Assets – Inventories • Inventory Accounting Methods § During a period of deflation, the FIFO method typically produces • • • the highest cost of goods sold expense • cost of goods sold values at current cost of inventory items the lowest ending valuation of inventory undervalued inventories on the balance sheet Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -36

Assets Current Assets – Inventories • Inventory Accounting Methods § During a period of deflation, the LIFO method typically produces • • • the lowest cost of goods sold expense • cost of goods sold values below the current cost of inventory items the highest ending valuation of inventory values on the balance sheet that are at current cost Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -37

Assets Current Assets – Prepaid Expenses • Expenses paid in advance § Insurance § Rent § Property taxes § Utilities • Included in current assets if they expire within one year or one operating cycle • Generally not material to the balance sheet Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -38

Assets Property, Plant, and Equipment (PP&E) • Encompasses a company’s fixed assets • Not used up during annual operations • Produce economic benefits for more than one year • Have physical substance • Shown at book value on the balance sheet Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -39

Assets Property, Plant, and Equipment (PP&E) • The relative proportion of fixed assets in a company’s asset structure will largely be determined by the nature of the business. • Manufacturing firms typically have higher percentages of fixed assets than retailers or wholesalers. • Firms with newly purchased assets will have higher percentages of fixed assets than firms with older fixed assets. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -40

Assets Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -41

Assets Property, Plant, and Equipment • • • Land Buildings Leasehold improvements Construction in

Assets PP&E – Land • Property used in business • Not investment property Copyright

Assets PP&E – Buildings • Buildings owned by the company § Stores § Corporate

Assets PP&E – Leasehold Investments • Additions made to leased structures • Improvements made to leased structures • Revert to the property owner when the lease expires • Amortized by the lessee over the economic life of the improvement (or the life of the lease) Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -45

Assets PP&E – Construction in Progress • Costs of constructing new buildings that are

Assets PP&E – Equipment • Original cost of machinery and equipment used in business

Assets PP&E – Depreciation • Fixed assets (with the exception of land) are depreciated over the period of time they benefit the firm. • Method of allocating the cost of longlived assets • Original cost less estimated residual value is spread over the asset’s expected life. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -48

Assets PP&E – Depreciation Methods • Straight-line method allocated an equal amount of expense to each year of the depreciation period. • Accelerated methods apportions larger amounts of expense to earlier years of the asset’s depreciable life. • Units-of-production method bases depreciation expense on actual use. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -49

Assets Example – Assume that Sage Inc. purchases an artificial ski mountain for its Phoenix flagship store in order to demonstrate skis and allow prospective customers to test-run skis on a simulated course. The cost of the mountain is $50, 000 and is expected to have a five-year useful life and $0 salvage value at the end of that period. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -50

Assets Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -51

Assets Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -52

Assets Goodwill • Arises when one company acquires another company for a price in excess of the fair market value of the net identifiable assets acquired • Evaluated annually § If no loss of value has occurred, goodwill remains on the balance sheet. § If the book value exceeds the fair value, the excess must be written off as an impairment expense Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -53

Assets Other Assets • Can include a multitude of other noncurrent items § Property held for sale § Start-up costs associated with a new business § Cash surrender value of life insurance policies § Long-term advance payments § Intangible assets (other than goodwill) Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -54

Liabilities • Represent claims against assets • Current liabilities § Must be satisfied in one year or one operating cycle • Noncurrent liabilities § Obligations with maturities beyond one year Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -55

Liabilities Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -56

Liabilities Current Liabilities • Accounts payable • Notes payable • Current portion of long-term debt • Accrued liabilities • Unearned revenue Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -57

Liabilities Current Liabilities – Accounts Payable • Short-term obligations that arise from credit extended by suppliers for the purchase of goods and services • Eliminated when the bill is satisfied • Increase and decrease depending on credit policies, economic conditions, and cyclical nature of operations Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -58

Liabilities Current Liabilities – Notes Payable • Also referred to as short-term debt • Short-term obligations in the form of promissory notes • Lines of credit to suppliers or financial institutions Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -59

Liabilities Current Liabilities – Current Maturities of Long-term Debt • Portion of the principal of long -term debt that will be repaid during the upcoming year Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -60

Liabilities Current Liabilities – Accrued Liabilities • Result from recognition of an expense prior to actual payment of cash • Reserve accounts § Set up for the purpose of estimating obligations for items such as warranty costs, sales returns, or restructuring charges § Identified in the notes to the financial statements Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -61

Liabilities Current Liabilities – Accrued Liabilities Example – Assume that a company has a $100, 000 note outstanding with 12% interest due in semiannual installments on March 31 and September 30. For a balance sheet prepared on December 31, interest will be accrued for three months (October, November, and December). The December 31 balance sheet would include an accrued liability of $3, 000: $10, 000 x 0. 12 = $12, 000 annual interest $12, 000/12 = $1, 000 monthly interest $1, 000 x 3 = $3, 000 accrued interest for three months Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -62

Liabilities Current Liabilities – Unearned Revenue • Also called deferred credits • Result from payments received in advance for services and products • Transferred to a revenue account when the service is performed or the product is delivered Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -63

Liabilities Deferred Taxes • Result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income • Depreciation methods are the most common source for temporary differences. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -64

Liabilities Deferred Taxes • Other temporary differences arise from methods used to account for § Installment sales § Long-term contracts and leases § Warranties and service contracts § Pensions and other employee benefits § Subsidiary investment earnings Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -65

Liabilities Deferred Taxes • Permanent differences in income tax accounting do not affect deferred taxes. § Municipal bond revenue § Life insurance premiums Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -66

Liabilities Deferred Taxes • Valuation allowance § Used to reduce deferred tax assets to expected realizable amounts § Used when it is more likely than not that some of the deferred tax assets will not be realized Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -67

Liabilities Example – Assume that a company has a total annual revenue of $500, 000, expenses other than depreciation of $250, 000, and a depreciation expense of $100, 000 for tax accounting and $50, 000 for financial reporting. The income for tax reporting purposes would be computed two ways, assuming a 34% tax rate: Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -68

Liabilities Taxes actually paid ($51, 000) are less than the tax expense ($68, 000) reported in the financial statements. To reconcile the $17, 000 difference between the expense recorded and the cash outflow, there is a deferred tax liability of $17, 000: Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -69

Liabilities Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -70

Liabilities Deferred Taxes • Deferred taxes are not always classified as current liabilities. • They may also appear on the balance sheet as a § current asset § noncurrent liability Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -71

Liabilities Noncurrent Liabilities • Long-term debt • Capital lease obligations • Postretirement benefits other than pensions • Commitments and contingencies • Hybrid securities Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -72

Liabilities Noncurrent Liabilities – Long-term Debt • • • Bonds Long-term notes payable Mortgages Obligations under leases Pension liabilities Long-term warranties Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -73

Liabilities Noncurrent Liabilities – Capital Lease Obligations • Are, in substance, a “purchase” rather than a “lease” • Affect both balance sheet and income statement • Disclosures found in the notes, often under both the PP&E note and the commitments and contingencies note Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -74

Liabilities Noncurrent Liabilities – Pensions and Postretirement Benefits • Pensions are cash compensation paid to retired employees. • Postretirement benefits are benefits other than pensions that employers promise to pay for retired employees. • Can appear under the liability section of the balance sheet Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -75

Liabilities Noncurrent Liabilities – Commitments and Contingencies • Commitments refer to contractual agreements that will have a significant financial impact in the future. • Contingencies refer to potential liabilities (such as possible damage awards assessed in lawsuits). • Intended to draw attention to the fact that required disclosures can be found in the notes to the financial statements. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -76

Liabilities Noncurrent Liabilities – Hybrid Securities • Have the characteristics of both debt and equity • Also called mandatorily redeemable preferred stock • Financial instrument is preferred stock, but the issuing company must retire the shares at a future date. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -77

Stockholders’ Equity • Also called shareholders’ equity • Residual interest in assets that remains after deducting liabilities • Owners bear greatest risk and benefit from greatest rewards. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -78

Stockholders’ Equity Common Stock • Shareholders § do not ordinarily receive a fixed return § have voting privileges in proportion to ownership interest § can benefit through price appreciation § can suffer through price depreciation Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -79

Stockholders’ Equity Common Stock • Dividends are declared at the discretion of a company’s board of directors • Amount listed on the balance sheet is based on the par or stated value of the shares issued (which bears no relationship to actual market price). Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -80

Stockholders’ Equity Additional Paid-In Capital • Reflects the amount by which the original sales price of the stock shares exceeded par value Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -81

Stockholders’ Equity Retained Earnings • Sum of every dollar a company has earned sinception less any payments made to shareholders • Funds a company has elected to reinvest in the operations of the business rather than pay out in stock • Measurement of all undistributed earnings Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -82

Stockholders’ Equity Retained Earnings • Key link between the income statement and the balance sheet • Unless there are unusual transactions affecting the retained earnings account, Beginning retained earnings ± Net Ending income – Dividends = retained (loss) earnings Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -83

Stockholders’ Equity Other Equity Accounts • Preferred stock • Accumulated other comprehensive income (expense) • Treasury Stock • Employee benefit trusts • Equity attributable to noncontrolling interests Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -84

Stockholders’ Equity Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -85

Stockholders’ Equity Other Equity Accounts – Preferred Stock • Carries a fixed annual dividend payment • Carries no voting rights Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -86

Stockholders’ Equity Other Equity Accounts – Accumulated Other Comprehensive Income (Expense) • Unrealized gains or losses in the market value of investments in available-for-sale securities • Any change in the excess of additional pension liability over unrecognized prior service cost • Certain gains and losses on derivative financial instruments • Foreign currency translation adjustments resulting from converting financial statements from a foreign currency into U. S. dollars Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -87

Stockholders’ Equity Other Equity Accounts – Treasury Stock • Repurchased shares of stock that are not retired • Shown as an offsetting account Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -88

Stockholders’ Equity Other Equity Accounts – Equity Attributable to Noncontrolling Interests • Represents the equity interest a firm has in companies whose financial statement have been consolidated with the firm’s statements but that are not 100% owned by the firm Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -89

Quality of Financial Reporting • Economic recession of 2008 and many market gyrations since can be traced directly to overvaluation of balance sheet assets. • When financial reporting does not reflect economic reality quality and usefulness are significantly impaired. • Type of debt used to finance assets, commitments and contingencies, and the classification of leases relate directly to quality of financial reporting. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -90

Quality of Financial Reporting • “Commitments and Contingencies” disclosure in the notes to financial statements provide important information about off-balance sheet financing and other complex financing arrangements. • Enron is a prime example of a company with enormous activity reported in the “Commitments and Contingencies” disclosure. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -91

Other Balance Sheet Items • Corporate balance sheets are not limited to the accounts described in this chapter. • The reader of annual reports will encounter additional accounts and will find many of the same accounts listed under different titles. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -92

Copyright Notice All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2 -93