Intermediate Accounting I-Kieso-Chapter 5

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What other name is the balance sheet known by?

The statement of financial position.

What does the balance sheet help to predict?

The amounts, timing, and uncertainty of future cash flows.

What is the usefulness of the balance sheet?

1-Provides a basis for computing rates of return and evaluating the capital structure of the enterprise.
2-Assess a companies risk and future cash flows
3-To assess a company's liquidity, solvency, and financial flexibility.

Liquidity

The amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid.

Solvency

The ability of a company to pay its debts as they mature.

Financial Flexibility

Measures the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.

What affects a companies financial flexibility?

Liquidity and solvency

What are the benefits to a company having high flexibility?

1-Better able to survive bad times
2-Better able to recover from unexpected setbacks
3-Allows them to take advantage of profitable and unexpected investment opportunities.
4-Lower risk of failure

What are the major limitations of the balance sheet?

1-Most assets and liabilities are reported at historical cost.
2-Companies use judgements and estimates
3-The balance sheet omits many items that are of financial value but cannot be recorded objectively.

What is the meaning of a classified balance sheet?

Means that similar items are grouped together to arrive at significant totals.

What items should companies report separately on a classified balance sheet?

1-Assets that differ in type or expected function from the companies central operations
2-Assets and liabilities with different implications for the companies financial flexibility.
3-Assets and liabilities with different liquidity characteristics.

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.

What is the operating cycle?

The average time between when a company acquires materials and supplies and when it receives cash for the sale of the product.

How is it determined whether to use one year of operating cycle to determine current assets?

If a company has several operating cycles in one year a company uses the one year period, if the operating cycle is more than one year they use the longer period.

Cash

Generally considered to consist of currency and demand deposits.

Demand deposits

Money available on demand at a financial institute.

Cash equivalents

Short term highly liquid investments that will mature within three months or less.

What reason would company exclude some cash from current assets?

Cash that is restricted for purposed other than current obligations can be excluded from current assets.

Three types of debt and equity securities

Held-to-maturity
Trading
Available for Sale

Held-to-maturity

Debt securities that a company has the positive intent and ability to hold to maturity.

Trading

Debt and equity security bought and held primarily for sale in the near term to generate income on short-term price differences

Available-for-sale

Debt and equity securities not classified as held-to-maturity or trading securities.

How should trading securities be reported on the balance sheet?

Trading securities should be reported as current assets whether they are current or non-current.

How should held-to-maturity and available for sale securities be classified on the balance sheet?

Held-to-maturity and available for sale securities could be classified as current or non-current based on the circumstances.

How should receivables arising from unusual transactions be classified?

Receivables from unusual transactions should be classified as long term unless expected to collect within one year. Ex. sale of property or loan to employee.

In order to present inventories properly what information should be disclosed?

Companies should disclose the basis of valuation for inventories. (ex. FIFO and LIFO)

How should prepaid expenses be treated on the balance sheet?

Prepaid expenses should be included on the balance sheet under current assets if the benefits from it will be received within one year or the operating cycle, whichever is longer.

What are the four types of long term investments?

1-Investments in securities, such as bonds, common stock, or long term notes.
2-Investments in tangible fixed assets not currently used in operations.
3-Investments set aside in special fund, pension fund, or plant expansion.
4-Investments in non-consolidated subsidiaries.

Property, Plant, and Equipment

Tangible long lived assets used in the regular operations of business. Ex. land, buildings, machinery, wasting resources. These are either depreciated or depleted.

Intangible Assets

Lack physical substance and are not financial instruments.

What items are considered intangible assets?

Patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists.

Current Liabilities

Obligations that a company reasonably expects to liquidate either thru the use of current assets or creation of other current liabilities.

What items would be considered current liabilities?

1-Payables resulting from the acquisition of goods and services-accounts payable
2-Collections received in advance for the delivery of goods or performance of service.
3-Other liabilities whose liquidation will take place within the operating cycle-ex. long term bonds to be paid in current period.

Why would a liability that is payable within the next year sometimes not be included in current liabilities?

Payables that are due in the current year are not included in current liabilities when the company expects to refinance the debt through another long term issue or to retire the debt out of non-current assets.

Working Capital

The excess of current assets over current liabilities

Long Term Liabilities

Obligations that a company does not reasonably expect to liquidate within the normal operating cycle.

What items would most commonly be long term liabilities?

Bonds payable, notes payable, some deferred income tax amounts, lease obligations, and pension obligations.

When may a company classify a long term liability as a current liability?

They can be considered current liabilities when they mature within the current operating cycle and will require the use of current assets to pay.

What are the three types of long term liabilities?

1-Obligations arising from specific financing situations-ex-issuance of bonds
2-Obligations arising from the ordinary operations of the company-ex-pension obligations
3-Obligations that depend on the occurrence of one or more future events to confirm the amount payable-ex-service warranty.

Stockholders Equity sections

Capital Stock
Additional Paid-In Capital
Retained Earnings

What two sections may retained earnings be divided into?

Unappropriated
Restricted

Unappropriated Retained Earnings

The amount that is usually available for dividend distribution

Restricted Retained Earnings

The amount restricted by bond indentures or other loan agreements.

Balance Sheet-Account Form

A way to present the classified balance sheet, that lists assets, by sections on the left side and liabilities and stockholders equity by section on the right side.

What is the main disadvantage of the account form for the classified balance sheet?

The need for a sufficiently wide space to present the items side by side.

Balance Sheet-Report Form

The report form of the classified balance sheet lists the sections one above the other on the same page.

What is the primary purpose of the statement of cash flows?

The primary purpose of the statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period.

What does a statement of cash flows report?

1-Cash effects of operations during a period
2-Investing transactions
3-Financing Transactions
4-Net increase or decrease in cash for the period

What questions does the statement of cash flows help to answer?

1-Where did the cash come from during the period
2-What was the cash used for during the period?
3-What was the change in the cash balance during the period?

What are the sections of the statement of cash flows?

Operating activities
Investing activities
Financing activities

Operating activities

Involve the cash effects of transactions that enter into the determination of net income

Investing activities

Includes making and collecting loans and acquiring and disposing of investments and PPE

Financing activities

Involves liability and owners equity items. They include obtaining resources from owners and providing them with a return on their investment and borrowing money from creditors and repaying the amounts borrowed.

What is the value of the statement of cash flows?

The Statement of Cash Flows helps users evaluate liquidity, solvency, and financial flexibility.

What are some of the sources that are used to prepare the statement of cash flows?

1-Comparative balance sheet
2-The current income statement
3-Selected transaction data

What are the four steps to preparing the statement of cash flows?

1-Determine the cash provided by (or used in) operating activities
2-Determine the cash provided by or used in investing and financing activities
3-Determine the change (increase or decrease) in cash during the period
4-Reconcile the change in cash with the beginning and ending cash balance.

How can the cash provided by operating activities be defined?

The excess of cash receipts over cash payments from operating activities.

What could be considered significant non-cash activities?

1-Issuance of common stock to purchase assets
2-Conversion of bonds into common stock
3-Issuance of debt to purchase assets
4-Exchanges of long lived assets

Where are significant non-cash activities reported?

Significant non-cash activities are reported in either a separate schedule at the bottom of the statement of cash flows or in separate notes to the financial statements.

How can the amount of net cash provided by operating activities be interpreted?

A high amount indicates that a company is able to generate sufficient cash from operations to pay bills without further borrowing. A low or negative amount of net cash from operating activities indicates that a company may have to borrow to pay bills.

Current Cash Debt Ratio

Net Cash Provided by Operating Activities/Avg. Current Liabilities= Current Cash Debt Coverage Ratio

What is a good ratio for the current cash debt ratio?

1:1

What does the current cash debt ratio indicate?

The current cash debt ratio indicates whether the company can pay off its current liabilities from its operations in a given year.

Cash Debt Coverage Ratio

Net Cash Provided by Operating Activities/Avg. Total Liabilities= Cash debt coverage ratio

What is the purpose of the cash debt coverage ratio?

Provides information on financial flexibility and indicates a companies ability to repay its liabilities from net cash provided by operating activities.

How can the cash debt coverage ratio be interpreted?

The higher the ratio, the less likely the company will experience difficulty in meeting its obligations as they come due.

Free Cash Flow

The amount of discretionary cash flow a company has. The greater the number the better.

Formula for Free Cash Flow

Net Cash Provided by Operating Activities - Capital expenditures - dividends =Free Cash Flow

What questions can a free cash flow analysis answer?

1.Is the company able to pay its dividends without the use of ext. financing?
2. If the business operations decline, will the company be able to maintain its needed capital investment
3. What if the amount of discretionary cash flow that can be used for additional investment?

What are the four types of information that are supplemental to account titles and amounts presented in the balance sheet?

Contingencies
Accounting Policies
Contractual Situations
Fair Values

Contingencies

Material events that have an uncertain outcome

Accounting Policies

Explanations of the valuation method used or the basic assumptions made concerning inventory valuations, depreciation methods, investments and subsidiaries

Contractual Situations

Explanations of certain restrictions or covenants attached to specific assets or liabilities.

Fair Values

Disclosures of fair values particularly for financial instruments

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