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C H A P T E R 5

C H A P T E R 5. BALANCE SHEET AND STATEMENT OF CASH FLOWS. Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield. Learning Objectives. Explain the uses and limitations of a balance sheet. Identify the major classifications of the balance sheet.

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C H A P T E R 5

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  1. C H A P T E R 5 BALANCE SHEET AND STATEMENT OF CASH FLOWS Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

  2. Learning Objectives • Explain the uses and limitations of a balance sheet. • Identify the major classifications of the balance sheet. • Prepare a classified balance sheet using the report and account formats. • Determine which balance sheet information requires supplemental disclosure. • Describe the major disclosure techniques for the balance sheet. • Indicate the purpose of the statement of cash flows. • Identify the content of the statement of cash flows. • Prepare a statement of cash flows. • Understand the usefulness of the statement of cash flows.

  3. Balance Sheet and Statement of Cash Flows Balance Sheet Statement of Cash Flows Usefulness Limitations Classification Additional information reported Techniques of disclosure Purpose Content and format Preparation Usefulness

  4. Balance Sheet Usefulness of the Balance Sheet • Evaluating the capital structure. • Assess risk and future cash flows. • Analyze the company’s: • Liquidity, • Solvency, and • Financial flexibility LO 1 Explain the uses and limitations of a balance sheet.

  5. Balance Sheet • Analyze the company’s: • Liquidity“how quickly will my assets convert to cash “ Creditor are interested in short term liquidity ratios .This ratios indicates whether a company will have the resources to pay its obligations Greater Liquidity = lower risk of failure • Solvency: the ability of a company to pay its debts as they mature.Companies with higher debt are more risky because they need more of their assets to meet their obligations higher debt = Lower solvency • Financial flexibility: ability to respond to threats or take advantage of opportunities Liquidity and Solvency affects a company's Financial flexibility. • Company with higher degree of Financial flexibility is better able to survive bad times and to take advantage of profitable opportunities • Greater Financial flexibility = lower risk of failure

  6. Balance Sheet Limitations of the Balance Sheet • Most assets and liabilities are reported at historical cost. • Use of judgments and estimates (e.g. useful life). • Many items of financial value are omitted, (when a company cannot record objectively). e.g.the knowledge and skills of the employees. LO 1 Explain the uses and limitations of a balance sheet.

  7. Balance Sheet Classification in the Balance Sheet • Three General Classifications • Assets, Liabilities, and Stockholders’ Equity • Companies further divide these classifications: Illustration 5-1 LO 2 Identify the major classifications of the balance sheet.

  8. Balance Sheet Current Assets Cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer. (Current assets are presented in order of liquidity ) Illustration 5-2 LO 2 Identify the major classifications of the balance sheet.

  9. Balance Sheet Review The correct order to present current assets is a. Cash, accounts receivable, prepaid items, inventories. b. Cash, accounts receivable, inventories, prepaid items. c. Cash, inventories, accounts receivable, prepaid items. d. Cash, inventories, prepaid items, accounts receivable. LO 2 Identify the major classifications of the balance sheet.

  10. Balance Sheet – “Current Assets” Cash • Generally any monies available “on demand.” • Cash equivalents - short-term highly liquid investments that mature within three months or less. • Restrictions or commitments must be disclosed. Illustration 5-3 e.g. a company restricted cash to meet an obligation due currently. LO 2 Identify the major classifications of the balance sheet.

  11. Balance Sheet – “Current Assets” Short-Term Investments Portfolios Type Valuation Classification Held-to-Maturity Debt Amortized Cost Current or Noncurrent Trading Debt or Equity Fair Value Current Available- for-Sale Debt or Equity Fair Value Current or Noncurrent LO 2 Identify the major classifications of the balance sheet.

  12. Balance Sheet – “Current Assets” Short-Term Investments Illustration 5-5 Balance Sheet Presentation of Investments in Securities LO 2 Identify the major classifications of the balance sheet.

  13. Balance Sheet – “Current Assets” Receivables • Claims held against customers and others for money, goods, or services. • Accounts receivable – oral promises • Notes receivable – written promises • Major categories of receivables should be shown in the balance sheet or the related notes. LO 2 Identify the major classifications of the balance sheet.

  14. Balance Sheet – “Current Assets” Current Assets: Cash $ 346 Accounts receivable 500 Less allowance for doubtful accounts 25 475 Inventory 812 Total current assets $1,633 Accounts Receivable – Presentation Options 1 2 Current Assets: Cash $ 346 Accounts receivable, net of $25 allowance 475 Inventory 812 Total current assets $1,633 LO 2 Identify the major classifications of the balance sheet.

  15. Balance Sheet – “Current Assets” Receivables Illustration 5-6 Balance Sheet Presentation of Receivables LO 2 Identify the major classifications of the balance sheet.

  16. Balance Sheet – “Current Assets” Inventories • Company discloses: • Basis of valuation (e.g., lower-of-cost-or-market). • Method of pricing/ cash flow assupmtion (e.g., FIFO or LIFO). Illustration 5-7 LO 2 Identify the major classifications of the balance sheet.

  17. Balance Sheet – “Current Assets” Payment of cash, that is recorded as an asset because service or benefit will be received in the future. Prepaid Expenses Cash Payment Expense Recorded BEFORE Prepayments often occur in regard to: • rent • maintenance on equipment • insurance • supplies • advertising LO 2 Identify the major classifications of the balance sheet.

  18. Balance Sheet – “Current Assets” Prepaid Expenses Illustration 5-9 LO 2 Identify the major classifications of the balance sheet.

  19. Balance Sheet – “Current Assets” Current Assets - “Summary” Cash and other assets a company expects to • convert into cash, • sell, or • consume either in one yearor in the operating cycle, whichever is longer. LO 2 Identify the major classifications of the balance sheet.

  20. Balance Sheet – “Noncurrent Assets” Long-Term Investments • Generally consists of four types: • Securities e.g. bonds, common stock or long-term notes • Fixed assets not currently used in operation e.g. land held for speculation. • Special funds e.g. pension fund • Nonconsolidated subsidiaries or affiliated companies. • *Companies expect to hold long-term investments for many years. They usually present them on the balance sheet just below “current assets” in a separate section called “Investment” LO 2 Identify the major classifications of the balance sheet.

  21. Balance Sheet – “Noncurrent Assets” Long-Term Investments Securities • bonds, • stock, and • long-term notes For marketable securities, management’s intent determines current or noncurrent classification. LO 2 Identify the major classifications of the balance sheet.

  22. Balance Sheet – “Noncurrent Assets” Long-Term Investments Fixed Assets • Land held for speculation LO 2 Identify the major classifications of the balance sheet.

  23. Balance Sheet – “Noncurrent Assets” Long-Term Investments Special Funds • Sinking fund • Pensions fund • Cash surrender value of life insurance LO 2 Identify the major classifications of the balance sheet.

  24. Balance Sheet – “Noncurrent Assets” Long-Term Investments Nonconsolidated Subsidiaries or Affiliated Companies LO 2 Identify the major classifications of the balance sheet.

  25. Balance Sheet – “Noncurrent Assets” Property, Plant, and Equipment Assets of a durable nature used in the regular operations of the business. LO 2 Identify the major classifications of the balance sheet.

  26. Balance Sheet – “Noncurrent Assets” Intangibles • Lack physical substance and are not financial instruments. • Limited life intangibles amortized. • Indefinite-life intangibles tested for impairment. LO 2 Identify the major classifications of the balance sheet.

  27. Balance Sheet – “Exercise” Intangibles (BE5-5): Mickey’s adjusted trial balance contained the following asset accounts at December 31, 2010: Prepaid Rent $12,000; Goodwill $40,000; Franchise Fees Receivable $2,000; Franchises $47,000; Patents $33,000; Trademarks $10,000. Prepare the intangible assets section of the balance sheet. Intangibles Goodwill $ 40,000 Franchises 47,000 Patents 33,000 Trademarks 10,000 Total $130,000 LO 2 Identify the major classifications of the balance sheet.

  28. Balance Sheet – “Noncurrent Assets” Other Assets This section should include only unusual items sufficiently different from assets in the other categories(this section vary widely in practice) e.g. long-term prepaid expenses, prepaid pension cost, non-current receivables, deferred income tax, property held for sale, and restricted cash and security. LO 2 Identify the major classifications of the balance sheet.

  29. Balance Sheet Current Liabilities “Obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities.” LO 2 Identify the major classifications of the balance sheet.

  30. Balance Sheet Long-Term Liabilities “Obligations that a company does not reasonably expect to liquidate within the normal operating cycle.” All covenants and restrictions must be disclosed. LO 2 Identify the major classifications of the balance sheet.

  31. Balance Sheet – “Exercise” Long-Term Liabilities (BE5-8): Included in Adams Company’s December 31, 2010, trial balance are the following accounts: Accounts Payable $240,000; Pension Liability $375,000; Discount on Bonds Payable $24,000; Advances from Customers $41,000; Bonds Payable $400,000; Wages Payable $27,000; Interest Payable $12,000; Income Taxes Payable $29,000. Prepare the long-term liabilities section of the balance sheet. Long-term liabilities Pension liability $375,000 Bonds payable 400,000 Discount on bonds payable (24,000) Total 751,000 LO 2 Identify the major classifications of the balance sheet.

  32. Balance Sheet Owners’ Equity Three parts, (1) Capital Stock, (2) Additional Paid-In Capital, and (3) Retained Earnings (undistributed earnings). Illustration 5-15 LO 2 Identify the major classifications of the balance sheet.

  33. Balance Sheet Classification Exercise Account Classification (a) Investment in preferred stock (a) Current asset/Investment (b) Treasury stock (b) Stockholders’ Equity (c) Common stock (c) Stockholders’ Equity (d) Cash dividends payable (d) Current liability (e) Accumulated depreciation (e) Contra-asset (f) Interest payable (f) Current liability (g) Deficit (g) Stockholders’ Equity (h) Trading securities (h) Current asset (i) Unearned revenue (i) Current liability LO 2 Identify the major classifications of the balance sheet.

  34. Balance Sheet - Format • Classified Balance Sheet • Account form • Report form Accounting Trends and Techniques—2007 (New York: AICPA) indicates that all of the 600 companies surveyed use either the “report form” (524) or the “account form” (76), sometimes collectively referred to as the “customary form.” LO 3 Prepare a classified balance sheet using the report and account formats.

  35. Balance Sheet - Format Account Form Illustration 5-16 LO 3 Prepare a classified balance sheet using the report and account formats.

  36. Illustration 5-16 Balance Sheet -Format Report Form LO 3

  37. Additional Information Reported There are normally four types of information that are supplemental to account titles and amounts presented in the balance sheet: • Contingencies: material events that have an uncertain outcome • Accounting Policies: explanation of the valuation methods used or the basic assumptions made concerning inventory valuation, depreciation method, etc. • Contractual Situations: certain restrictions or covenant attached to specific assets or liabilities. • Fair Values: disclosures of FV, particularly for financial instruments LO 4 Determine which balance sheet information requires supplemental disclosure.

  38. Techniques of Disclosure • Parenthetical Explanations (in the body of the statement) • Notes • Cross-Reference and Contra Items • Supporting Schedules • Terminology *General rule: when in doubt, disclose. “ Its better to disclose too much information than not enough” LO 5 Describe the major disclosure techniques for the balance sheet.

  39. The Statement of Cash Flows One of the three basic objectives of financial reporting is “assessing the amounts, timing, and uncertainty of cash flows.” LO 6 Indicate the purpose of the statement of cash flows.

  40. The Statement of Cash Flows Purpose of the Statement of Cash Flows • To provide relevant information about the cash receipts and cash payments of an enterprise during a period. • The statement provides answers to the following questions: • Where did the cash come from? • What was the cash used for? • What was the change in the cash balance? LO 6 Indicate the purpose of the statement of cash flows.

  41. The Statement of Cash Flows Content and Format • Three different activities: • Operating, • Investing, • Financing Illustration 5-24 LO 7 Identify the content of the statement of cash flows.

  42. The Statement of Cash Flows Content and Format Operating Investing Financing Cash inflows and outflows from operations. Cash inflows and outflows from non-current assets. Cash inflows and outflows from non-current liabilities and equity. The statement’s value is that it helps users evaluate liquidity, solvency, and financial flexibility. LO 7 Identify the content of the statement of cash flows.

  43. The Statement of Cash Flows Illustration 5-25 LO 7 Identify the content of the statement of cash flows.

  44. Classification of Typical Inflows and Outflows

  45. Classification of Typical Inflows and Outflows

  46. Classification of Typical Inflows and Outflows

  47. Common adjustments to Net Income (Loss): • Depreciation and amortization expense. • Gain or loss on disposition of long-term assets. • Change in current assets and current liabilities

  48. The Statement of Cash Flows Preparation Information obtained from several sources: (1) comparative balance sheets, (2) the current income statement, and (3) selected transaction data. Three Major Steps: Step 1. Determine change in cash. Step 2. Determine net cash flow from operating activities. Step 3. Determine net cash flows from investing and financing activities. LO 8 Prepare a statement of cash flows.

  49. The Statement of Cash Flows Statement of Cash Flows:On January 1, 2010, in its first year of operations, Telemarketing Inc. issued 50,000 shares of $1 par value common stock for $50,000 cash. The company rented its office space, furniture, and telecommunications equipment and performed marketing services throughout the first year. In June 2010 the company purchased land for $15,000. Illustration 5-26 shows the company’s comparative balance sheets at the beginning and end of 2010. LO 8 Prepare a statement of cash flows.

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