Copyright © 2015 McGraw-Hill Education. All rights reserved. Chapter 3 The Balance Sheet and Financial Disclosures.

Copyright © 2015 McGraw-Hill Education. All rights reserved.

Chapter 3

The Balance Sheet andFinancial Disclosures

Balance SheetLO3-1

(Statement of Financial Position)• Reports a company’s financial position at a point in time• Organized array of assets, liabilities, and shareholders’

equity–grouped in common characteristics

Balance Sheet: Usefulness and Limitations

Usefulness:• Liquidity—a company’s ability to pay its current

obligations• Long-term solvency—indicates:• Riskiness of a company with regard to the amount of

liabilities in its capital structure• Financial flexibility

Limitations:• Does not portray the market value of the entity • Heavily reliant on estimates rather than

determinable amounts

LO3-1

Classification of ElementsLO3-2

Classification of Elements: AssetsCURRENT ASSETS• Assets expected to be converted to cash within the

coming year or within the normal operating cycle of the business if that’s longer than one year

LO3-2

Use cash to acquire raw materials

Convert raw materials to finished product

Deliver product to customer

Collect cash from customer

1

2

3

4

Operating Cycle of a Typical Manufacturing Company

Classification of Elements: AssetsCURRENT ASSETS • Assets expected to be converted to cash within the

coming year or within the normal operating cycle of the business if that’s longer than one year

Cash and cash equivalents Short-term investments Accounts receivable Inventories Prepaid expenses

LO3-2

Current Assets—PetSmart, Inc.LO3-2

Classification of Elements: Assets

CURRENT ASSETS

Cash Equivalents:• Maturity date of three months or less from the date

of purchase

LO3-2

On hand In BanksCash

Bank draftsCashier’s checksMoney orders

Also:

Commercial paper

Money market funds

U.S. treasury bills

LO3-2


CURRENT ASSETSShort-Term Investments• Investments in stock and debt securities of other

corporations • That the company has the ability and intent to sell

within the next 12 months or operating cycle, whichever is longer

Short-Term Investments

Held to maturity

Trading securities

Securities available for sale

LO3-2


CURRENT ASSETSAccounts Receivable• Result from the sale of goods or services on credit• Often referred to as trade receivables• Nontrade receivables result from loans by the

companyNotes receivable• Supported by a formal agreement or note that

specifies payment terms

LO3-2


CURRENT ASSETSInventories

Finished goods

Work in process

Raw materials

Inventories Disclosure—Intel Corp.

LO3-2


CURRENT ASSETSPrepaid Expenses• Represent assets recorded when expenses are paid

in advance creating benefits beyond the current period

• Current or noncurrent depends on when its benefits will be realized

ExamplesPrepaid rent and prepaid insurance

LO3-2

Current assets include cash and all other assets expected to become cash or be consumed:

a. Within one year.b. Within one operating cycle.c. Within one year or one operating cycle,

whichever is shorter. d. Within one year or one operating cycle,

whichever is longer.

Concept Check √


NONCURRENT ASSETS• Assets expected to provide economic benefits

beyond the next year, or operating cycleInvestmentsProperty, Plant, and EquipmentIntangible AssetsOther Assets

LO3-2

Noncurrent Assets—PetSmart, Inc.LO3-2

Noncurrent assets

Classification of Elements: AssetsNONCURRENT ASSETS INVESTMENTS• Assets not used directly in operationsExamplesEquity and debt securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes

LO3-2

Classification of Elements: AssetsNONCURRENT ASSETS PROPERTY, PLANT, AND EQUIPMENT• Tangible, long-lived assets used in the operations of

the business• Reported as a single amount in the balance sheet, at

original cost less accumulated depreciation

ExamplesLand, buildings, equipment, machinery, and furniture,

as well as natural resources, such as mineral mines, timber tracts, and oil wells.

LO3-2


NONCURRENT ASSETS INTANGIBLE ASSETS• Generally represent exclusive rights• Valuable resources in generating future revenues• Reported in the balance sheet net of accumulated

amortization• Much of the value is not reported in the balance sheet

ExamplesPatents, copyrights, and franchises

LO3-2


NONCURRENT ASSETS OTHER ASSETS• Include deferred charges and any noncurrent asset

not included in one of the other classifications

LO3-2

LO3-2

Which of the following is most likely to be reported as a noncurrent asset:

a. Accounts receivableb. Buildingsc. Prepaid rentd. Inventories

Concept Check √

Buildings generally benefit the company for several years. The other items listed above are generally realized as cash or consumed within one year.

LO3-2

Which of the following represents tangible, long-lived assets used in the operations of the business?

a. Current assetsb. Investmentsc. Property, plant, and equipmentd. Intangible assets

Concept Check √

Current assets are not long-lived, investments are not used directly in operations, and intangible assets have no physical substance.

Classification of Elements: Liabilities

CURRENT LIABILITIES• Obligations expected to be satisfied through the use

of current assets or the creation of other current liabilities• Expected to be satisfied within one year or the

operating cycle, whichever is longerExamplesAccounts and notes payableDeferred revenuesAccrued liabilitiesCurrent maturities of long-term debt

LO3-3


CURRENT LIABILITIESACCOUNTS PAYABLE• Obligations to suppliers of merchandise or

services purchased on account• Payment usually due in 30 to 60 days

NOTES PAYABLE• Written promises to pay cash at some future date• Usually require the payment of explicit interest in

addition to the original obligation amount

LO3-3


CURRENT LIABILITIESDEFERRED REVENUES• Represent cash received from a customer for goods or

services to be provided in a future periodExamplePurchase of a gift card

ACCRUED LIABILITIES• Represent obligations created when expenses have been

incurred but will not be paid until a subsequent reporting period

ExamplesAccrued salaries payable, accrued interest payable, and accrued taxes payable

LO3-3

Classification of Elements: LiabilitiesCURRENT LIABILITIESCURRENT MATURITIES OF LONG-TERM DEBTExample A $1,000,000 note payable requiring $100,000 in principal payments to be made in each of the next 10 years

ExamplesLong-term notes, loans, mortgages, bonds payable, and long-term debt payable in installments

LO3-3

$1,000,000

$900,000 $100,000Long-term liability Current liability


LONG-TERM LIABILITIES• Obligations that will not be satisfied in the next year or

operating cycle, whichever is longer• Do not require use of current assets or the creation of current

liabilities for payment• Impact on future cash flows and long-term solvency is assessed

by reporting payment terms, interest rates, and other details in a disclosure note

ExamplesLong-term notesBondsPension obligationsLease obligations

LO3-3

Liabilities—PetSmart, Inc.LO3-3

LO3-3

The key distinction between current liabilities and long-term liabilities is:a. The amount of the obligation to be satisfied –

large versus small.b. To whom the obligation is owed – those inside

versus outside of the company. c. The length of time until the obligation is

expected to be satisfied – Less than versus more than one year, or operating cycle if longer.

d. The nature of the obligation – determinable amount versus estimated amount.

Concept Check √

Classification of Elements: Shareholders’ Equity

• Arises primarily from(1) Paid-in capital and (2) Retained earnings

• Residual amount derived by subtracting liabilities from assets:

Assets − Liabilities = Shareholders’ Equity• Includes other equity components such as accumulated

other comprehensive (loss) income

LO3-3

Shareholders’ Equity—PetSmart, Inc.LO3-3

$

$ $

$

Financial Disclosures

• Convey additional information about account balances in basic financial statements

ExamplesAllowance for uncollectible accounts and information about common stock

LO3-4

(1) By including additional information on the face of the statement following a financial statement itemFinancial statement

disclosures are provided

(2) In disclosure notes that often include supporting schedules

Disclosure Notes• Explain data presented in financial statements

themselves, or provide information not directly related to any specific item in the statements

Examples

• Must include a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions

LO3-4

• Pension plans • Leases• Long-term debt• Income taxes

• Investments

• Property, plant, and equipment• Employee benefit plan

Specific Disclosure NotesSummary of Significant Accounting Policies• Conveys valuable information about a company’s choices

from among various alternative accounting methodsSubsequent Events• Occurs after a company’s fiscal year end but before the

financial statements are issuedExamples• Issuance of debt or equity securities • Business combination or the sale of a business• Sale of assets• Event that sheds light on the outcome of a loss

contingency

LO3-4

Specific Disclosure Notes

Noteworthy Events and Transactions• Related-party transactions• Errors• Fraud• Illegal acts

LO3-4

Management Discussion and Analysis• Provides a biased but informed perspective of a company’s: • Operations

• Liquidity

• Capital resources

• Included in the annual reports of public companies

Management’s Responsibilities Section

• Asserts the responsibility of management for the company’s annual report and internal control procedures

• Requires corporate executives to personally certify the financial statements as per the Sarbanes Oxley Act of 2002

LO3-5

Auditors’ Report

• Provides the final statement user with an independent and professional opinion about:• Fairness of the representations in the financial

statements• Effectiveness of internal controls• Whether or not the financial statements are in

conformity with generally accepted accounting principles• Financial statements that “present fairly” the financial

position prompt an unqualified opinion• Sometimes circumstances cause the auditors’ report to

include an explanatory paragraph in addition to the standard wording, even though the report is unqualified

LO3-6

Auditors’ Report

• Calls attention to problems that might exist in the financial statements• Qualified opinion—contains an exception to the

standard unqualified opinion• Adverse opinion—results from (a) nonconformity

with GAAP and (b) inadequate disclosures• Disclaimer—results from limitation or restriction of

the scope of the examination• Assess firm’s ability to continue as a going concern• Most informative in case of any deviations from

standard unqualified opinion

LO3-6

Compensation of Directors and Top Executives

• Compensation gap between executives and lower-level employees is much wider in the United Statesthan in most other industrialized countries• Historically, related disclosures were not clear• Total compensation paid to executives led to confusion• SEC requires corporations to provide for disclosures on

compensation to directors and executivesProxy statement• Contains disclosures on compensation to directors and

executives• Must be reported each year to all shareholders, along

with annual report

LO3-6

LO3-6

Which disclosure provides an independent and professional opinion about the fairness of the representations in the financial statements and about the effectiveness of internal controls?

a. Auditors’ report.b. Proxy statement. c. Management’s discussion and analysis.d. Summary of significant accounting policies.

Concept Check √

Risk Analysis—Using Financial Statement Information• Goal is to gain a glimpse of the future from past and

present data using various tools and techniquesComparative financial statements• Allow financial statement users to compare year-to-

year financial position• Help an analyst detect and predict trendsHorizontal analysis• Allow analysts to enhance their comparison by

expressing each item as a percentage of that same item in the financial statements of another year

Vertical analysis• Involves expressing each item in the financial

statements as a percentage of an appropriate corresponding total but within the same year

LO3-7

Risk Analysis—Using Financial Statement InformationRatio analysis• Most common way of comparing accounting numbers

to evaluate the performance and risk of a firm• Allows analysts to control for size differences over

time and among firmsDefault risk• Concerned about a company’s ability to pay its

obligations when they come dueOperational risk• Relates more to how adept a company is at

withstanding various events that might impair its ability of earning profits

LO3-7

Liquidity Ratios

• Liquidity — refers to the readiness of assets to be converted to cash• Common measures of liquidity are:

• Provide information about a company’s ability to pay its short-term obligations

LO3-8

Current ratio Current assetsCurrent liabilities

=

Acid-test ratio (or quick ratio) Quick assetsCurrent liabilities

=

Current Ratio

• Relation between current assets and current liabilities• Popular measure of a company’s ability to satisfy its

short-term obligationsExample: Consider that PetSmart has current assets of

$1,318,243 and current liabilities of $794,345 at the end of its February 2, 2014, fiscal year.

• Working capital = Current Assets − Current Liabilities

LO3-8

Current ratio $1,318,243$794,345

=

1.66=

Acid-Test Ratio (Or Quick Ratio)

• Provides a more stringent indication of a company’s ability to pay its current obligations• Numerator excludes inventories, prepaid items,

restricted cash, and deferred taxes• Numerator includes of unrestricted cash, short-term

investments, and accounts receivableExamplePetSmart's quick assets at the end of its February 2, 2014, fiscal year total $358,307.

LO3-8

Acid-test ratio$358,307$794,345

=

0.45=

LO3-8

Which of the following transactions would increase a company’s liquidity ratios?a. Receive cash from customers on accounts

receivable.b. Purchase office supplies with cash. c. Pay dividends to shareholders.d. Borrow cash by signing a three-year note.

Concept Check √

Cash increases while current liabilities remain the same, thus increasing the company’s ability to pay existing short-term debt.

Financing Ratios

• Provide some indication of the riskiness of a company with regard to its ability to pay its long-term debts• Common financing ratios are:

LO3-8

Debt to equity ratio Total liabilitiesShareholders’ equity

=

Times interest earned ratio

Net income + Interest expense + Income taxesInterest expense

=

Debt to Equity Ratio

• Compares resources provided by creditors with resources provided by owners• Indicates the extent of reliance on creditors, rather

than owners• Provides a measure of creditors’ protection in the

event of insolvency• Other things being equal: the higher the ratio the higher the risk

LO3-8


ExamplePetSmart's liabilities at the end of its February 2, 2014, fiscal year total $1,428,186, and stockholders’ equity totals $1,093,782.

Debt to equity ratio $1,428,186$1,093,782

=

1.31=

LO3-8


• More meaningful if compared to some standard such as an industry average or a competitor

Example

LO3-8

Industry average debt to equity ratio

2.36

PetSmart’s debt to equity ratio

1.31

Indicates fewer liabilities in Petsmart’s capital structure than does the average firm in its industry

>

LO3-8

Geisner Inc. has total assets of $1,000,000 and total liabilities of $600,000. The industry average debt to equity ratio is 1.20. Calculate Geisner’s debt to equity ratio and indicate whether the company’s default risk is higher or lower than the average of other companies in the industry.a. 0.60; Higher default risk.b. 0.60; Lower default risk. c. 1.50; Higher default risk.d. 1.50; Lower default risk.

Debt to equity ratio = $600,000 / $400,000* = 1.50

* Equity = Assets − Liabilities = $1,000,000 − $600,000 = $400,000

Concept Check √


Relationship Between Risk and Profitability• Higher the debt to equity ratio, higher the risk to

shareholders• Favorable financial leverage: Earning a return on

borrowed funds that exceeds the cost of borrowing the funds

LO3-8

Favorable Financial Leverage LO3-8

Income before interest and income taxesLess: Interest expenseIncome before income taxesLess: Income tax expense (40%)Net income

$8,000,000 $8,000,000(800,000) (2,400,000)

$7,200,000 $5,600,000(2,880,000) (2,240,000)$4,320,000 $3,360,000

Return on shareholders’ equity$4,320,000

$40,000,000$3,360,000

$20,000,000

Alternative 1 Alternative 2


=

= 10.8% 16.8%

A newly formed corporation is attempting to determine the appropriate mix of debt and equity. The initial capitalization goal is $50 million. The capitalization mix alternatives have been narrowed to two: (1) $10 million in debt and $40 million in equity and (2) $30 million in debt and $20 million in equity. Income before interest and taxes will be $8 million. The interest rate on debt is 8% and the income tax rate is 40%. Calculate the net income and return on shareholders’ equity for both alternatives.

10,000,000 × 8%

30,000,000 × 8%

Unfavorable Financial Leverage LO3-8

Income before interest and income taxesLess: Interest expenseIncome before income taxesLess: Income tax expense (40%)Net income

$3,000,000 $3,000,000(800,000) (2,400,000)

$2,200,000 $600,000(880,000) (240,000)

$1,320,000 $360,000

Return on shareholders’ equity$1,320,000

$40,000,000$360,000

$20,000,000



=

= 3.3% 1.8%

A newly formed corporation is attempting to determine the appropriate mix of debt and equity. The initial capitalization goal is $50 million. The capitalization mix alternatives have been narrowed to two: (1) $10 million in debt and $40 million in equity and (2) $30 million in debt and $20 million in equity. Income before interest and taxes will be $3 million. The interest rate on debt is 8% and the income tax rate is 40%. Calculate the net income and return on shareholders’ equity for both alternatives.

10,000,000 × 8%

30,000,000 × 8%

Times Interest Earned Ratio

• Indicates the margin of safety provided to creditors• Designed to measure the ability of a company to

satisfy its fixed debt obligationsExample: PetSmart's financial statements for the fiscal year ended February 2, 2014, report:

LO3-8

($ in thousands)$419,520

52,479239,444

$711,443

Times interest earned ratio $711,443$52,479= 13.6=

Income before interest and taxesIncome taxesInterest expenseNet income

International Financial Reporting Standards LO3-9

U.S. GAAP IFRSBalance Sheet Presentation

No minimum requirements Specifies a minimum list of items to be presented in the balance sheet

Some companies use the statement of financial position title

Changed the title of balance sheet to statement of financial position, although companies are not required to use that title

Current assets and liabilities are presented before noncurrent assets and liabilities

Balance sheets often report noncurrent items first

Segment ReportingRequires companies to report information about reported segment profit or loss, including certain revenues and expenses, segment assets, and the basis of measurement.

Along with items included in U.S. GAAP, it requires that companies also disclose totalliabilities of its reportable segments.

Reporting by Operating Segment• Facilitates the financial statement analysis of diversified

companiesWHAT IS A REPORTABLE OPERATING SEGMENT?• Determined by using a management approach• Evident from the structure of the enterprise’s internal

organization• Component of an enterprise—formally defined by

characteristics:• Engages in business activities from which it may

recognize revenues and incur expenses• Whose operating results are regularly reviewed by the

enterprise’s chief operating decision maker• For which discrete financial information is available

APPENDIX 3

What Amounts Are Reported by an Operating Segment?

Required disclosures:• General information about the operating segment• Information about reported segment profit or loss,

including certain revenues and expenses included in reported segment profit or loss, segment assets, and the basis of measurement• Reconciliations of the totals of segment revenues,

reported profit or loss, assets, and other significant items to corresponding enterprise amounts• Interim period information

APPENDIX 3

Business Segment Information Disclosure— Abbott Laboratories, Inc.

APPENDIX 3

Reporting by Geographic Area• U.S. GAAP requires an enterprise to report certain

geographic information:• Revenues from external customers• Long-lived assets other than financial instruments,

long-term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets

APPENDIX 3

Information About Major Customers

• Helps the financial analysts in providing information concerning the extent to which a company’s prosperity depends on one or more major customers

• If 10% or more of the revenue of an enterprise is derived from transactions with a single customer, the facts must be disclosed by the company

APPENDIX 3

End of Chapter 3

Copyright © 2015 McGraw-Hill Education. All rights reserved. Chapter 3 The Balance Sheet and Financial Disclosures.

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