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Intermediate Accounting: Chapter 5
Terms in this set (51)
Balance sheet - Financial statement that shows the financial condition of a company at the end of a period by reporting its assets, liabilities, and stockholders' equity
Usefulness of the Balance Sheet
Usefulness of the Balance Sheet - By providing information on assets, liabilities, and stockholders' equity, the balance sheet provides a basis for computing rates of return and evaluating the capital structure of the enterprise. Analysts also use information in the balance sheet to assess a company's risk2 and future cash flows. In this regard, analysts use the balance sheet to assess a company's liquidity, solvency, and financial flexibility.
Liquidity - The amount of time that is expected for an asset to be realized or otherwise converted into cash or until a liability has to be paid. In general, the greater a company's liquidity, the lower its risk of failure.
The ability of a company to pay its debts as they mature. A company with a high level of long-term debt relative to assets has lower solvency than a similar company with a low level of long-term debt.
Financial flexibility - The ability of a company to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities. A company's liquidity and solvency affect its financial flexibility.
Limitations of the Balance Sheet
Some of the major limitations of the balance sheet are:
1. Most assets and liabilities are reported at historical cost. As a result, the information provided in the balance sheet is often criticized for not reporting a more relevant fair value.
2. Companies use judgments and estimates to determine many of the items reported in the balance sheet.
3. The balance sheet necessarily omits many items that are of financial value but that a company cannot record objectively.
ELEMENTS OF THE BALANCE SHEET
ELEMENTS OF THE BALANCE SHEET:
1. ASSETS. Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events
2. LIABILITIES. Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
3. EQUITY. Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.
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. Companies present current assets in the balance sheet in order of liquidity.
The operating cycle is the average time between when a company acquires materials and supplies and when it receives cash for sales of the product (for which it acquired the materials and supplies).
- The cycle operates from cash through inventory, production, receivables, and back to cash.
- When several operating cycles occur within one year (which is generally the case for service companies), a company uses the one-year period. If the operating cycle is more than one year, a company uses the longer period.
Current Asset Items and Basis for Valuation
Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current assets section, and their (bases of valuation), are:
1. Cash and cash equivalents (Fair Value)
2. Short-term investments (Generally, fair value)
3. Receivables (Estimated amount collectible)
4. Inventories (Lower-of-cost-or-market)
5. Prepaid expense (Cost)
- A company does not report these five items as current assets if it does not expect to realize them in one year or in the operating cycle, whichever is longer.
Cash - Cash is generally considered to consist of currency and demand deposits (monies available on demand at a financial institution).
Cash equivalents are short-term highly liquid investments that will mature within three months or less. Most companies use the caption "Cash and cash equivalents," and they indicate that this amount approximates fair value.
A company must disclose any restrictions or commitments related to the availability of cash.
Companies group investments in debt and equity securities into three separate portfolios for valuation and reporting purposes:
1. Held-to-maturity: Debt securities that a company has the positive intent and ability to hold to maturity.
2. Trading: Debt and equity securities bought and held primarily for sale in the near term to generate income on short-term price differences.
3. Available-for-sale: Debt and equity securities not classified as held-to-maturity or trading securities.
Receivables - A company should clearly identify any anticipated loss due to uncollectibles, the amount and nature of any nontrade receivables, and any receivables used as collateral.
- Major categories of receivables should be shown in the balance sheet or the related notes. For receivables arising from unusual transactions (such as sale of property, or a loan to affiliates or employees), companies should separately classify these as long-term, unless collection is expected within one year.
To present inventories properly, a company discloses the basis of valuation (e.g., lower-of-cost-or-market) and the cost flow assumption used (e.g., FIFO or LIFO).
Prepaid Expenses - A company includes prepaid expenses in current assets if it will receive benefits (usually services) within one year or the operating cycle, whichever is longer.
- Prepaid expenses are current assets because if they had not already been paid, they would require the use of cash during the next year or the operating cycle.
- A company reports prepaid expenses at the amount of the unexpired or unconsumed cost.
Long-term investments, often referred to simply as investments, normally consist of one of four types:
1. Investments in securities, such as bonds, common stock, or long-term notes.
2. Investments in tangible fixed assets not currently used in operations, such as land held for speculation.
3. Investments set aside in special funds such as a sinking fund, pension fund, or plant expansion fund. This includes the cash surrender value of life insurance.
4. Investments in 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 "Investments." Realize that many securities classified as long-term investments are, in fact, readily marketable. But a company does not include them as current assets unless it intends to convert them to cash in the short-term—that is, within a year or in the operating cycle, whichever is longer. As indicated earlier, securities classified as available-for-sale are reported at fair value, and held-to-maturity securities are reported at amortized cost.
Property, plant, and equipment
Property, plant, and equipment - Assets of a durable nature used in the regular operations of the business. These assets consist of physical property (such as land, buildings, machinery) and wasting resources (timberland, minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., oil reserves) these assets.
Intangible assets - Assets that lack physical substance and that are not financial instruments. Intangible assets derive their value from the rights and privileges granted to the company using them. They are normally classified as long-term assets. Companies write off (amortize) limited-life intangible assets over their useful lives, and they periodically assess indefinite-life intangibles (including goodwill) for impairment.
Other Assets - The items included in the section "Other assets" vary widely in practice. Some include items such as long-term prepaid expenses, prepaid pension cost, and noncurrent receivables. Other items that might be included are assets in special funds, deferred income taxes, property held for sale, and restricted cash or securities.
- A company should limit this section to include only unusual items sufficiently different from assets included in specific categories.
Current liabilities - The obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities. This concept includes payables resulting from the acquisition of goods and services; (2) collections received in advance for the delivery of goods or performance of services; and (3) other liabilities whose liquidation will take place within the operating cycle.
Current liabilities include
Current Liabilities include:
1. Payables resulting from the acquisition of goods and services: accounts payable, wages payable, taxes payable, and so on.
2. Collections received in advance for the delivery of goods or performance of services, such as unearned rent revenue or unearned subscriptions revenue.
3. Other liabilities whose liquidation will take place within the operating cycle, such as the portion of long-term bonds to be paid in the current period or short-term obligations arising from the purchase of equipment.
Current Liability and Debt Refinancing
At times, a liability that is payable within the next year is not included in the current liabilities section. This occurs either when the company expects to refinance the debt through another long-term issue or to retire the debt out of noncurrent assets. This approach is used because liquidation does not result from the use of current assets or the creation of other current liabilities.
Working capital - The excess of total current assets over total current liabilities; represents the net amount of a company's relatively liquid resources. Also called net working capital.
long-term liabilities - Obligations that a company expects to pay at some date beyond the normal operating cycle. Examples are bonds payable, notes payable, some deferred income tax amounts, lease obligations, and pension obligations. Also referred to as long-term debt. Companies provide a great deal of supplementary disclosure for long-term liabilities because they often are subject to covenants and restrictions for the protection of lenders.
Long-term liability types
Generally, long-term liabilities are of three types:
1. Obligations arising from specific financing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable.
2. Obligations arising from the ordinary operations of the company, such as pension obligations and deferred income tax liabilities.
3. Obligations that depend on the occurrence or non-occurrence of one or more future events to confirm the amount payable, or the payee, or the date payable, such as service or product warranties and other contingencies.
Owners' (stockholders') equity
Owners' (stockholders') equity - The ownership claim on a company's total assets. The owners' equity section of the corporate balance sheet consists of capital stock, additional paid-in capital, and retained earnings. The ownership accounts (stockholders' equity) in a corporation differ considerably from ownership accounts in a partnership or proprietorship. Partners show separately their permanent capital accounts and the balance in their temporary accounts (drawing accounts). Proprietors ordinarily use a single capital account that handles all of the owner's equity transactions.
STOCKHOLDERS' EQUITY SECTION
STOCKHOLDERS' EQUITY SECTION
1. CAPITAL STOCK. The par or stated value of the shares issued.
2. ADDITIONAL PAID-IN CAPITAL. The excess of amounts paid in over the par or stated value.
3. RETAINED EARNINGS. The corporation's undistributed earnings.
Account form - Presentation in a classified balance sheet that lists assets by sections on the left side and liabilities and stockholders' equity by sections on the right side.
Report form - Presentation in a classified balance sheet that lists liabilities and stockholders' equity directly below assets on the same page.
A standardized score with a mean of 0 and a standard deviation of 1. Scores in the distributions of two different measures, such as a measure of IQ and a measure of reading comprehension, are often converted to z-scores so that the distributions can be easily compared with one another. (P.227)
Statement of cash flows
Statement of cash flows - A basic financial statement that provides information about cash receipts, cash payments, and the net change in cash resulting from the operating, investing, and financing activities of a company during the period, in a format that reconciles the beginning and ending cash balances.
Content and Format of the Statement of Cash Flows
Companies classify cash receipts and cash payments during a period into three different activities in the statement of cash flows—operating, investing, and financing activities, defined as follows.
1. Operating activities involve the cash effects of transactions that enter into the determination of net income.
2. Investing activities include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plant, and equipment.
3. Financing activities involve liability and owners' equity items. They include (a) obtaining resources from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed.
Overview of the Preparation of the Statement of Cash Flows
Companies obtain the information to prepare the statement of cash flows from several sources:
(1) comparative balance sheets,
(2) the current income statement, and
(3) selected transaction data.
Cash provided by operating activities
Cash provided by operating activities is the excess of cash receipts over cash payments from operating activities. Companies determine this amount by converting net income on an accrual basis to a cash basis. To do so, they add to or deduct from net income those items in the income statement that do not affect cash. This procedure requires that a company analyze not only the current year's income statement but also the comparative balance sheets and selected transaction data.
Significant Noncash Activities
Not all of a company's significant activities involve cash. Examples of significant noncash activities are:
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.
- Significant financing and investing activities that do not affect cash are not reported in the body of the statement of cash flows. Rather, these 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. Such reporting of these noncash activities satisfies the full disclosure principle.
Usefulness of the Statement of Cash Flows
- Creditors examine the cash flow statement carefully because they are concerned about being paid.
- Substantial increases in receivables and/or inventory can explain the difference between positive net income and negative net cash provided by operating activities.
Current cash debt coverage ratio
Current cash debt coverage ratio - Measure of liquidity that indicates a company's ability to pay its short-term debts. Computed as cash provided by operating activities divided by average current liabilities.
- The higher the current cash debt coverage ratio, the less likely a company will have liquidity problems.
Cash debt coverage ratio
Cash debt coverage ratio - Measure of solvency that indicates a company's ability to repay its liabilities from cash generated from operations (without having to liquidate productive assets). Computed as the ratio of cash provided by operating activities to total debt, as represented by average total liabilities.
- The higher this ratio, the less likely the company will experience difficulty in meeting its obligations as they come due.
- It signals whether the company can pay its debts and survive if external sources of funds become limited or too expensive.
Free Cash Flow
Free cash flow - Measure of the cash remaining from operating activities after adjusting for capital expenditures and dividends paid. Some analysts prefer free cash flow to the measure of cash provided by operating activities because free cash flow takes into account the outflows needed to maintain current operations.
Free Cash Flow
In a free cash flow analysis, we first deduct capital spending, to indicate it is the least discretionary expenditure a company generally makes. (Without continued efforts to maintain and expand facilities, it is unlikely that a company can continue to maintain its competitive position.) We then deduct dividends. Although a company can cut its dividend, it usually will do so only in a financial emergency. The amount resulting after these deductions is the company's free cash flow. Obviously, the greater the amount of free cash flow, the greater the company's financial flexibility.
Free Cash Flow
Questions that a free cash flow analysis answers are:
1. Is the company able to pay its dividends without resorting to external financing?
2. If business operations decline, will the company be able to maintain its needed capital investment?
3. What is the amount of discretionary cash flow that can be used for additional investment, retirement of debt, purchase of treasury stock, or addition to liquidity?
Money which is spent on construction, land, machinery etc which has an expected working life of more than one year - investments in the future of a business.
SUPPLEMENTAL BALANCE SHEET INFORMATION
SUPPLEMENTAL BALANCE SHEET INFORMATION
1. CONTINGENCIES. Material events that have an uncertain outcome.
2. ACCOUNTING POLICIES. Explanations of the valuation methods used or the basic assumptions made concerning inventory valuations, depreciation methods, investments in subsidiaries, etc.
3. CONTRACTUAL SITUATIONS. Explanations of certain restrictions or covenants attached to specific assets or, more likely, to liabilities.
4. FAIR VALUES. Disclosures of fair values, particularly for financial instruments.
Underlying Concepts - The basis for including additional information should meet the full disclosure principle. That is, the information should be of sufficient importance to influence the judgment of an informed user.
Contingency - Material events with an uncertain future. The uncertainty can involve a possible gain (gain contingency) or possible loss (loss contingency) that will ultimately be resolved when one or more future events occur or fail to occur. Typical gain contingencies are tax operating loss carryforwards or company litigation against another party. Typical loss contingencies relate to litigation, environmental issues, possible tax assessments, or government investigations.
Financial instruments - Assets consisting of cash, accounts receivable, an ownership interest, or a contractual right to receive or obligation to deliver cash or another financial instrument.
Companies use notes if they cannot conveniently show additional explanations as parenthetical explanations.
- Companies commonly use notes to disclose the following: the existence and amount of any preferred stock dividends in arrears, the terms of or obligations imposed by purchase commitments, special financial arrangements and instruments, depreciation policies, any changes in the application of accounting principles, and the existence of contingencies.
- Notes therefore must present all essential facts as completely and succinctly as possible. Careless wording may mislead rather than aid readers. Notes should add to the total information made available in the financial statements, not raise unanswered questions or contradict other portions of the statements.
Contra account - An account that reduces either an asset, liability, or owners' equity account. Examples include Accumulated Depreciation—Equipment and Discount on Bonds Payable. Use of contra accounts enables readers of financial statements to see the original cost of the asset, liability, or owners' equity account as well as the changes in the account to date.
Adjunct account - An account that increases either an asset, liability, or owners' equity account. An example is Premium on Bonds Payable, which, when added to the Bonds Payable account, describes the total bond liability of the company.
used to describe the appropriation of retained earnings
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