Chapter 3 The Balance Sheet and the Statement

Chapter 3 The Balance Sheet and the Statement of Changes in Stockholders’ Equity

Objectives Understand the purposes of the balance sheet. Define the elements of a balance sheet. Explain how to measure the elements of a balance sheet. Classify the assets of a balance sheet. Classify the liabilities of a balance sheet. Report the stockholders’ equity of a balance sheet.

3 Objectives Prepare a statement of changes in stockholders’ equity. Understand the other disclosure issues for a balance sheet. Describe the SEC integrated disclosures. Explain the reporting techniques used in an annual report.

4 FASB Statement of Concepts No. 5 …recommends that a full set of financial statements for an accounting period should show a company’s. . .

FASB Statement of Concepts No. 5 Financial position at the end of the period. Net income for the period. Comprehensive income for the period. Cash flows for the period. Investments by and distributions to owners for the period.

Interrelationship of Financial Statements Beginning Balance Sheet w Assets w Liabilities w Stockholders’ Equity Transactions and Events 6

Interrelationship of Financial Statements Income Statement w Revenues w Expenses Transactions and Events Statement of Cash Flows w Operating Activities w Investing Activities w Financing Activities 7

Interrelationship of Financial Statements Income Statement w Revenues w Expenses Statement of Cash Flows w Operating Activities w Investing Activities w Financing Activities Ending Balance Sheet w Assets w Liabilities w Stockholders’ Equity 8

9 Basic Accounting Equation Assets = Liabilities + Stockholders’ Equity Economic resources obligations Net assets

10 Liquidity The term liquidity is used to describe how quickly an asset can be converted into cash or a liability paid.

11 Financial Flexibility Financial flexibility refers to the ability of a company to use its financial resources to adapt to change.

12 Operating Capability Operating capability refers to the ability of a company to maintain a given physical level of operations.

Process for Disclosing Information on the Balance Sheet Identification of what items meet the definition of the elements. Measurement (valuation) of the elements. Reporting (classification) of the elements.

Elements of the Balance Sheet -Assets are probable future economic benefits obtained or controlled by a company as a result of past transactions or events.

Elements of the Balance Sheet -Assets The resource must be able to contribute directly or indirectly to the company’s future net cash inflows. The company must be able to obtain the future benefit and control others’ access to it. The transaction or event giving the company the right to or control over the benefit must have occurred.

Elements of the Balance Sheet -Assets may be natural or manmade, tangible or intangible, and exchangeable or useful in the company’s activities. 16

Elements of the Balance Sheet -Liabilities … of a company Liabilitiestoare transfer probable assets or provide futureservices sacrifices to other of economic entities in the benefits futurearising as a result fromofpresent past transactions obligations. . . L or events. 17

Elements of the Balance Sheet -Stockholders’ Equity Assets = Liabilities + Stockholders’ Equity is residual interest in the assets of a company that remain after deducting liabilities. 18

Measurement of the Elements of the Balance Sheet Present Value Net Realizable Value Current Market Value Current Cost Historical Cost

Measurement of the Elements of the Balance Sheet The historical cost of an The current cost of an asset is the exchange price The net assetrealizable is the amount valueofofcash in the in which (or equivalent) thatof would an asset is the amount Thetransaction current market value The presentcash value ofequivalent) an on theofasset was acquired. be required date of (or into an asset isasset the amount is the which net amount of issheet the balance to obtain the asset expected of cash (or equivalent) that discounted expected cash the sameinasset. to be converted the could be obtained on the inflows less ordinary the discounted operations of the date of the balance sheet expected cash company, outflows less any by selling the asset in an related to the asset. expected conversion costs. orderly liquidation. 20

Limitations of the Balance Sheet • Use of historical cost to value assets and liabilities does not help assess the likely amounts of future cash flows. • “Human resources” such as high-quality management or highly motivated workers are not included as assets. • Many of the amounts that a company reports are based on estimates. • In periods of inflation, the amounts listed do not show the “purchasing power” of assets and liabilities.

22 Current Assets Current assets are cash and other assets that are expected to be converted into cash, sold, or consumed within one year or the normal operating cycle, whichever is longer.

23 Operating Cycle …process andcycle sell the inventory, An operating is the average collect receivables, timeand taken by a the company to spend converting them back into cash for inventory, . . .

24 Current Assets Cash equivalents are risk-free securities, such as money market funds and treasury bills that will mature in three months or less from the date acquired by the holder. Cash includes cash on hand readily available in checking and savings accounts.

25 Current Assets Temporary investments in marketable securities include debt and equity securities that are classified as “trading securities” and “available-for-sale securities. ”

26 Current Assets Receivables include accounts receivable and notes receivable Inventories include goods held with short-term maturity dates. resaleestimated in the normal course They are listedfor at their business(net plus, in the case of a collectibleofamounts Prepaid items include manufacturing company, raw realizable values). insurance, rent, materials andoffice goods in process. supplies and taxes that will not be converted into cash but will be consumed.

27 Current Liabilities Current liabilities are those obligations whose liquidation is expected to require the use of existing current assets, or the creation of other current liabilities.

28 Long-Term Investments Investment items that management expects to hold for more than one year or the operating cycle, whichever is longer, are classified as long-term (noncurrent) investments.

Long-Term Investments A company makes investments for a variety of reasons. ü The company expects the market value of the investment to increase. ü The company wishes to receive income from interest or dividends. ü The company may desire to exercise control over another company or a supplier. ü The company may acquire property, plant, or equipment for future expansion.

30 Property, Plant, and Equipment Also called fixed assets Property, plant, and equipment includes the tangible assets used in the firm’s operations.

31 Intangible Assets Intangible assets are those noncurrent economic resources that are used in the operations of the business but have no physical existence. ® a registered trademark Trademarks Computer Goodwill Franchises Patents Copyrights software costs

32 Long-Term Liabilities Long-term liabilities are those obligations that are not expected to require the use of current assets or not expected to create current liabilities within one year or the normal operating cycle (if longer than a year).

33 Other Liabilities Deferred tax liabilities and obligations of a segment of the company that is being discontinued are examples of items that might be included in this section.

Conceptual Guidelines FASB suggested guidelines for developing homogeneous classes of assets and liabilities. þ Reporting assets according to their type or expected function in the central operations or other activities of the company. þ Reporting as separate items assets and liabilities that affect the financial flexibility of the company differently. þ Reporting assets and liabilities according to measurement method used to value the items.

35 Stockholders’ Equity Stockholders’ equity is the residual interest of the stockholders in the assets of the A partnership involves is two a AThe solecorporation proprietorship corporation. or more who have complex business is apersons single-owner agreed to combine their organization. Usually there company. capital and efforts in the is absentee ownership. operations of a company.

Stockholders’ Equity Components of Stockholders’ Equity ü Contributed capital ü Retained earnings ü Accumulated other comprehensive income

37 Stockholders’ Equity Contributed Capital Preferred stock Legal capital is the receives preference minimum amount of in declared stockholders’ equity that the dividends. corporation may not Common stock carries distribute as dividends. the right to vote at the P annual stockholders’ meeting and to share in residual profits.

38 Stockholders’ Equity Contributed Capital A corporation sells 100 shares of its $5 par common stock for $30 per share. Cash Common Stock, $5 par Additional Paid-in Capital on Common Stock 3, 000 500 2, 500

39 Stockholders’ Equity Contributed Capital A corporation sells 20 shares of its $100 par preferred stock for $110 per share. Cash Preferred Stock, $100 par Additional Paid-in Capital on Preferred Stock 2, 200 2, 000 200

40 Stockholders’ Equity Contributed Capital A corporation sells 100 shares of its no-par common stock at $50 per share. Cash Common Stock--No-Par Value 5, 000

41 Stockholders’ Equity Retained earnings is the total amount of corporate net income that has not been distributed to stockholders as dividends. Uses of net income To use in daily operations To maintain its productive facilities For growth

42 Stockholders’ Equity Retained earnings is the total amount of corporate net income that has not been distributed to stockholders as dividends. Uses of net income To use in daily operations To maintain its productive facilities For growth Click to review the balance sheet.

Stockholders’ Equity Comprehensive Unrealized increases income (gains) includesorboth decreases net income (losses) and other in thecomprehensive market value of income. investments Accumulated in availableother comprehensive for-sale securities. income might include four items: Transaction adjustments from converting the financial statements of a company’s foreign operations into U. S. dollars. Certain gains and losses on “derivative” financial instruments. Certain pension liability adjustments.

44 Stockholders’ Equity A company is required to report its total comprehensive income for the accounting period.

Statement of Changes in Stockholders’ Equity statement should show A This corporation must disclose the investments distributions changes inby itsand stockholders’ to owners during the issuing period, equity account when among other items. financial statements.

Statement of Changes in Stockholders’ Equity SCHEDULE A CARON MANUFACTURING COMPANY 46 Exhibit 3 -8 Statement of Changes in Stockholders’ Equity For Year Ended December 31, 2000 Accumulated Common Additional Other Stock Paid-in Retained Comprehensive $5 par Capital Earnings Income Total $65, 000 $143, 400 $ 64, 900 $10, 000 $283, 300 Balance, Jan. 1, 2000 Unrealized increase in value of availablefor-sale securities Net income Cash dividends paid Common stock issued 6, 500 Balance, Dec. 31, 2000 $71, 500 2, 000 62, 500 (11, 200) 30, 500 $173, 900 $116, 200 $12, 000 62, 500 (11, 200) 37, 000 $373, 600

Summary of Accounting Policies APB Opinion No. 22 requires that a company include a description of all significant accounting policies as an integral part of its financial statements. In particular, when these principles and methods involve-ü A selection from existing acceptable alternatives. ü Principles and methods peculiar to the industry in which the company operates. ü Unusual or innovative applications of GAAP.

48 Derivative Financial Instruments FASB Statement No. 133 Fair value is the requires a company to amount at which recognize all derivative the instrument financial instruments as either could be assets or liabilities on the purchased or sold balance sheet. in a current transaction These instruments should be between willing measured at fair value. parties.

Derivative Financial Instruments FASB Statement No. 133 also requires the following information: þ The type of derivative instruments it holds. þ Its objectives in holding the instruments. þ Its strategies for achieving these objectives.

50 Contingent Liabilities and Assets Loss No Probable (? ) or No Disclosure Yes and Reasonably estimated (? ) Reasonably possible Yes Report amount in financial statements Disclose in notes to the financial statements

51 Subsequent Events A subsequent event is one that occurs between the balance sheet date and the date of issuance of the annual report. End of Accounting Period Subsequent Events Annual Report Publication Date

52 SEC Disclosures The Securities and Exchange Commission has the legal authority to prescribe accounting principles and reporting practices for all regulated companies. A regulated company must file a Form 10 -K annual report with the SEC within 90 days of its fiscal year -end. This report must be filed electronically according to the EDGAR requirements. Continued

53 SEC Disclosures The SEC requires comparative balance sheets for two years and comparative income statements and statements of cash flows for three years. The SEC requires specific disclosures of important accounting information for a five-year period. These include net sales or operating revenues, income (loss) from continuing operations, and related earnings per share, total assets, long-term obligations and redeemable stock, and cash dividends declared per share.

54 Balance Sheet Formats Most companies use the report form or the account format in presenting their balance sheets.

55 Balance Sheet Formats Report Form Assets xxxx Total assets $xxx Liabilities and Stockholders’ Equity xxxx $xxx xxx Total liabilities and stockholders eq. $xxx

56 Balance Sheet Formats Account Form Liabilities and In the seldom-used financial Assets Stockholders’ Equity position format, current xxxx $xxx assets and current liabilities xxxx xxx are listed first to emphasize Total assets $xxx Total liab. & stock. eq. $xxx working capital.

57 Chapter 3