1 the balance sheet and income statement: a closer look chapter f10 © 2007 pearson custom...

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The Balance Sheet The Balance Sheet and and

Income Statement:Income Statement: A Closer Look A Closer Look

CHAPTER F10

© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Describe how the Describe how the balance sheet and balance sheet and income statement income statement were developed as were developed as

financial statements.financial statements.

Learning Objective 1:


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History and Development of the History and Development of the Balance Sheet & Income Balance Sheet & Income

StatementStatement Accounting “systems” have been around Accounting “systems” have been around

for a very long time (even B.C.). However, for a very long time (even B.C.). However, financial statements are a more recent financial statements are a more recent development. development.

Balance sheets have been traced back into Balance sheets have been traced back into the early 1600s. Balance sheets were the the early 1600s. Balance sheets were the primary, and often the only, financial primary, and often the only, financial statement prepared.statement prepared.


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In the late 1800s, crude income statements In the late 1800s, crude income statements began to develop. began to develop.

The income statement was not considered to The income statement was not considered to be very important due to the fact that banks be very important due to the fact that banks concentrated on balance sheet information concentrated on balance sheet information when making their lending decisions.when making their lending decisions.

History and Development of the Balance History and Development of the Balance Sheet & Income StatementSheet & Income Statement

© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing

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As companies began to finance their As companies began to finance their operations through the sale of stock operations through the sale of stock (instead of bank loans), the importance (instead of bank loans), the importance of reporting of reporting annualannual performance to performance to stockholders began to grow.stockholders began to grow.


StatementStatement


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Although it took a long time for the Although it took a long time for the income statement to “catch up” with the income statement to “catch up” with the balance sheet, they are now seen as very balance sheet, they are now seen as very important complements to one another. important complements to one another.

They both provide useful, although They both provide useful, although different, information for economic different, information for economic decision makers.decision makers.


StatementStatement


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Organization of the Balance Organization of the Balance SheetSheet

Remember the basic balance sheet equation:Remember the basic balance sheet equation:

Assets = Liabilities + Owners’ EquityAssets = Liabilities + Owners’ Equity Shown below is a very basic balance sheet that Shown below is a very basic balance sheet that

shows totals, but no details:shows totals, but no details:

Eliason and CompanyBalance Sheet

December 31, 2007

Liabilities $851,000Stockholders' equity 665,800

Total assets $1,516,800 Total liabilities & St. equity $1,516,800


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Explain the Explain the organization and organization and purpose of the purpose of the

classified balance classified balance sheet.sheet.



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Now, the same balance sheet, with details.First, the asset section.

Classified Balance Classified Balance SheetSheetASSETS

Current assets:Cash 100$ Accounts receivable 251,000Inventory 298,900Prepaid expenses 50,000

Total current assets: $600,000Long-term assets:

Land $125,000Plant & equipment $1,075,000LESS: Accum. depr. (283,200)

Plant & equipment, net 791,800Total long-term assets 916,800

Total assets $1,516,800


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Here is the Second Half of the Classified Balance Sheet

Classified Balance Classified Balance SheetSheet

LIABILITIESCurrent Liabilities:

Accounts payable $501,000Short-term note payable 50,000

Total current liabilities $551,000Long-term liabilities:

Bonds payable 300,000Total liabilities $851,000

STOCKHOLDERS' EQUITYCommon stock, No par $400,000Retained earnings 265,800

Total stockholders' equity 665,800Total liabilities & S.Equity $1,516,800

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Discussion Discussion QuestionsQuestions

Which of the two balance sheet Which of the two balance sheet presentations for Eliason and Company presentations for Eliason and Company do you think would be more useful in do you think would be more useful in predicting the future and timing of the predicting the future and timing of the company’s cash flow? Provide three company’s cash flow? Provide three specific examples to support your specific examples to support your position.position.


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The asset section of a classified balance The asset section of a classified balance sheet is divided into at least two major sheet is divided into at least two major sections:sections:

Current assetsCurrent assets include cash and those include cash and those other assets that are expected to become other assets that are expected to become cash within one year or the cash within one year or the operating operating cyclecycle, whichever is longer., whichever is longer.



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Long-term (or non-current) assetsLong-term (or non-current) assets are those are those that are expected to become cash after one that are expected to become cash after one year or will be used for more than one year, year or will be used for more than one year, or the operating cycle, whichever is longer.or the operating cycle, whichever is longer.

Occasionally, an asset needs to be Occasionally, an asset needs to be reclassified, either moving from current to reclassified, either moving from current to long term, or vice versa. long term, or vice versa.



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LiquidityLiquidity Assets are listed on the classified balance Assets are listed on the classified balance

in a descending order ofin a descending order of liquidity.liquidity. Liquidity is defined as “nearness to Liquidity is defined as “nearness to cash.” Cash is the most liquid of all cash.” Cash is the most liquid of all assets.assets.

Accounts receivable is more liquid than Accounts receivable is more liquid than factory equipment, because receivables factory equipment, because receivables are expected to be converted into cash in are expected to be converted into cash in the very near future (i.e., 30 to 60 days).the very near future (i.e., 30 to 60 days).


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Can you give examples of current assets Can you give examples of current assets that you think will never be converted into that you think will never be converted into cash? If so, why do you think they are cash? If so, why do you think they are classified as current assets?classified as current assets?

If a company has property, plant, and If a company has property, plant, and equipment classified as long-term assets, equipment classified as long-term assets, does this mean that the company cannot does this mean that the company cannot sell one of its buildings in the next year? sell one of its buildings in the next year? Explain your reasoning.Explain your reasoning.


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InvestmentsInvestments Most major corporations have Most major corporations have

significant investments in the securities significant investments in the securities (stocks and bonds) of other (stocks and bonds) of other corporations.corporations.

These investments could be either short These investments could be either short term or long term in nature, depending term or long term in nature, depending upon the intentions of management.upon the intentions of management.


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Intangible AssetsIntangible Assets IntangiblesIntangibles are long-term assets that are long-term assets that

do not have “physical substance.” do not have “physical substance.” Examples include patents, trademarks, Examples include patents, trademarks, and copyrights.and copyrights.

Intangibles with a defined economic life Intangibles with a defined economic life are amortized over their economic are amortized over their economic lives. lives. AmortizationAmortization is a cost allocation is a cost allocation procedure very similar to the way we procedure very similar to the way we depreciate long-term tangible assets.depreciate long-term tangible assets.


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Liabilities are also classified as either Liabilities are also classified as either current or long term.current or long term.

Current liabilitiesCurrent liabilities are those debts that are those debts that need to be paid within one year (or the need to be paid within one year (or the operating cycle). Examples would be operating cycle). Examples would be salaries payable or a 6-month note salaries payable or a 6-month note payable.payable.

Classification of Classification of LiabilitiesLiabilities


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Long-term liabilitiesLong-term liabilities are not due until are not due until after one year. Examples include after one year. Examples include bonds payable and long-term notes bonds payable and long-term notes payable.payable.

Again, occasionally a liability needs to Again, occasionally a liability needs to be reclassified, moving from current to be reclassified, moving from current to long term or vice versa. Can you give long term or vice versa. Can you give an example of why this might happen? an example of why this might happen?

Classification of Classification of LiabilitiesLiabilities


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Stockholders’ EquityStockholders’ Equity A classified balance sheet has at least A classified balance sheet has at least

two sections for stockholders’ equity:two sections for stockholders’ equity: Paid-in capitalPaid-in capital (also called(also called contributed contributed

capitalcapital)) is listed first. This represents the is listed first. This represents the amount invested by the stockholders amount invested by the stockholders when the corporation first issued the when the corporation first issued the shares of stock. This includes both shares of stock. This includes both common and preferred stock.common and preferred stock.


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Stockholders’ EquityStockholders’ Equity

The second section is The second section is retained retained earnings.earnings. Retained earnings Retained earnings represents the sum of all represents the sum of all profits since the inception of profits since the inception of the company minus any the company minus any dividends declared. dividends declared.


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Explain why recurring Explain why recurring and nonrecurring and nonrecurring

items are presented items are presented separately on the separately on the income statement.income statement.



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Recall the basic income statement equation: Recall the basic income statement equation: Revenues - Expenses = Net IncomeRevenues - Expenses = Net Income

Shown below is a very basic income Shown below is a very basic income statement that shows totals, but no details:statement that shows totals, but no details:

Eliason and CompanyIncome Statement

For the Year Ended December 31, 2007

Revenues $752,500LESS: Expenses 840,400 Net Loss ($87,900)

Organization of the Organization of the Income StatementIncome Statement


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Expanded Income Expanded Income StatementStatement

Eliason and CompanyIncome Statement

For the Year Ended December 31, 2007

Sales revenue $752,500LESS: Cost of goods sold 352,800 Gross profit on sales $399,700LESS: Operating expenses

Selling $60,250General & administrative 96,250

Total operating expenses 156,500 Operating income $243,200LESS: Interest expense 30,650 Income before taxes $212,550LESS: Income taxes 64,660 Income before extraordinary item $147,890Extraordinary loss 235,790 Net Loss ($87,900)

DetailedExpenseCategories

Subtotals

Nonrecurring

Item

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The expanded income statement results The expanded income statement results in a presentation of the regular, in a presentation of the regular, recurringrecurring items separate from irregular, items separate from irregular, nonrecurringnonrecurring items.items.

For the Eliason Company, the For the Eliason Company, the extraordinary itemextraordinary item is an example of a is an example of a nonrecurring item. We have to report it, nonrecurring item. We have to report it, because it did happen this year, but we because it did happen this year, but we want to send a signal telling the reader want to send a signal telling the reader not to expect it to happen again.not to expect it to happen again.

Recurring and Recurring and Nonrecurring ItemsNonrecurring Items


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Interpret the net of Interpret the net of tax disclosure of tax disclosure of

extraordinary items extraordinary items and discontinued and discontinued

operations.operations.



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For recurring items: income tax expense is For recurring items: income tax expense is shown as a separate line item. It is shown as a separate line item. It is typically the last expense deducted prior to typically the last expense deducted prior to the calculation of the calculation of income from continuing income from continuing operations.operations.

For nonrecurring items: the income tax For nonrecurring items: the income tax effect of the nonrecurring gain or loss is effect of the nonrecurring gain or loss is included in the calculation of the gain or included in the calculation of the gain or loss. The gain or loss is shown loss. The gain or loss is shown net of tax.net of tax.

Income Tax Income Tax DisclosureDisclosure


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Assume that your company had a Assume that your company had a nonrecurring gain of $100,000. That gain nonrecurring gain of $100,000. That gain would add to your income taxes for the would add to your income taxes for the year. year.

Assume that you pay 25% in income Assume that you pay 25% in income taxes. taxes.

Your reported gain would be $75,000 net Your reported gain would be $75,000 net of tax: $100,000 minus (25% X $100,000)of tax: $100,000 minus (25% X $100,000)

Net of Tax ExamplesNet of Tax Examples


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Similarly, if your company had a Similarly, if your company had a $100,000 loss, the loss would result in a $100,000 loss, the loss would result in a reduction of your taxes. reduction of your taxes.

Reducing your taxes gives you a smaller Reducing your taxes gives you a smaller net loss. net loss.

Again using a 25% tax rate, the loss Again using a 25% tax rate, the loss would be $75,000 net of tax.would be $75,000 net of tax.

Net of Tax ExamplesNet of Tax Examples


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If a company disposes of a business If a company disposes of a business component of the business, it would be component of the business, it would be accounted for as a accounted for as a discontinued discontinued operationoperation..

To be considered a To be considered a business componentbusiness component it has to a portion of the entity for which it has to a portion of the entity for which assets, results of operations, and assets, results of operations, and activities can be separately identified.activities can be separately identified.

Discontinued Discontinued OperationsOperations


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Another type of nonrecurring item is Another type of nonrecurring item is known as an known as an extraordinary item.extraordinary item. To be To be classified as extraordinary, an item must classified as extraordinary, an item must meet both of the following criteria:meet both of the following criteria: 1) unusual in nature, and1) unusual in nature, and 2) infrequent in occurrence.2) infrequent in occurrence.

What is extraordinary for one company What is extraordinary for one company might be considered ordinary for the might be considered ordinary for the next.next.

Extraordinary ItemsExtraordinary Items


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The following examples do The following examples do notnot qualify as qualify as extraordinary items. For each one, explain extraordinary items. For each one, explain specifically what criterion/criteria have not been specifically what criterion/criteria have not been met.met.

a) A citrus grower’s Florida crop is damaged by a) A citrus grower’s Florida crop is damaged by frost…frost…

b) A textile manufacturer with only one plant b) A textile manufacturer with only one plant moves to another location. It has not relocated moves to another location. It has not relocated a plant in twenty years and has no plans to do a plant in twenty years and has no plans to do so in the foreseeable future….so in the foreseeable future….


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ComprehensiveComprehensive IncomeIncome

In 1998, the FASB began requiring In 1998, the FASB began requiring firms to report firms to report comprehensive incomecomprehensive income in addition to the net income on the in addition to the net income on the traditional income statement.traditional income statement.

Comprehensive income measures all Comprehensive income measures all changes in equity from nonowner changes in equity from nonowner sources.sources.


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Comprehensive Comprehensive IncomeIncome

Most firms are choosing to include the Most firms are choosing to include the information about comprehensive information about comprehensive income in the income in the statement of statement of stockholders’ equitystockholders’ equity..

Alternatively, they could choose to Alternatively, they could choose to issue a issue a statement of comprehensive incomestatement of comprehensive income or a or a combined statement of income and combined statement of income and

comprehensive income. comprehensive income.


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Calculate earnings per Calculate earnings per share and properly share and properly disclose it on the disclose it on the

income statement. income statement.



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Earnings Per ShareEarnings Per Share One of the most highly scrutinized One of the most highly scrutinized

figures on financial reports is the figures on financial reports is the earnings per shareearnings per share (EPS). (EPS).

EPS shows the direct relationship EPS shows the direct relationship between company earnings and the between company earnings and the number of shares of common stock number of shares of common stock outstanding.outstanding.


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Earnings Per ShareEarnings Per Share

Basic and diluted EPS are always Basic and diluted EPS are always shown at the bottom of the income shown at the bottom of the income statement so that analysts and statement so that analysts and investors can easily find the data. investors can easily find the data.


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Basic Earnings Per Basic Earnings Per ShareShare

The basic EPS calculation is:The basic EPS calculation is:

Net income - Preferred dividends______ Net income - Preferred dividends______ WeightedWeighted average common shares average common shares outstandingoutstanding

Basic earnings per share reports actual Basic earnings per share reports actual data based on the shares outstanding on data based on the shares outstanding on the balance sheet date.the balance sheet date.


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Diluted Earnings Per Diluted Earnings Per ShareShare

A second EPS, known as A second EPS, known as diluted earning diluted earning per shareper share, shows worse case scenario for , shows worse case scenario for stockholders and potential investors.stockholders and potential investors.

If a company has If a company has convertible securitiesconvertible securities that could be converted into additional that could be converted into additional shares of common stock, those securities shares of common stock, those securities are are potentially dilutivepotentially dilutive. In other words, . In other words, the current common stockholders might the current common stockholders might suffer a reduction in the EPS if conversion suffer a reduction in the EPS if conversion occurred.occurred.


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Earnings Per Share Earnings Per Share ExampleExample

Assume XYZ Corp. had 50,000 common Assume XYZ Corp. had 50,000 common shares outstanding on 1/1/07. They issued shares outstanding on 1/1/07. They issued another 10,000 shares on 10/1/07.another 10,000 shares on 10/1/07.

Net income for 2007 totaled $166,000.Net income for 2007 totaled $166,000. XYZ has 10,000 shares of convertible XYZ has 10,000 shares of convertible

preferred stock outstanding. The dividend rate preferred stock outstanding. The dividend rate is $4 per share, and each share can be is $4 per share, and each share can be converted into 2 shares of common stock.converted into 2 shares of common stock.


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The first step is to calculate the weighted The first step is to calculate the weighted average number of common shares average number of common shares outstanding:outstanding:

DateDateSharesShares TimeTime WeightWeight 1/1 1/1 50,00050,000 9/12 9/12 37,50037,50010/110/1 60,00060,000 3/12 3/12 15,00015,000Weighted average sharesWeighted average shares 52,50052,500


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The second step is to calculate basic EPS:The second step is to calculate basic EPS:

$166,000 - (10,000 X $4) $166,000 - (10,000 X $4) = = $126,000$126,00052,500 shares52,500 shares 52,500 52,500

Basic EPS = $2.40Basic EPS = $2.40


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For diluted EPS, assume the 10,000 For diluted EPS, assume the 10,000 preferred shares are converted into 20,000 preferred shares are converted into 20,000 common shares at the beginning of the common shares at the beginning of the year:year:

$166,000 - $0 dividends$166,000 - $0 dividends = = $166,000$166,00052,500 + 20,000 shares52,500 + 20,000 shares 72,500 72,500

Diluted EPS = $2.29Diluted EPS = $2.29


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Describe the Describe the additional information additional information

provided by provided by comparative financial comparative financial

statements. statements.



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Most companies issue comparative Most companies issue comparative financial statements. These statements financial statements. These statements show the results for more than just the show the results for more than just the most recent year.most recent year.

The SEC requires registered firms to The SEC requires registered firms to reportreport balance sheetsbalance sheets for at least for at least twotwo years, years, income statements income statements for at least for at least threethree years, years, statements of equitystatements of equity for at least for at least threethree years. years.

Comparative Financial Comparative Financial StatementsStatements


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Comparative financial statements give the Comparative financial statements give the reader the opportunity to view its financial reader the opportunity to view its financial condition and results of operations for condition and results of operations for more than one year, to see the company in more than one year, to see the company in the perspective of its continuous history.the perspective of its continuous history.

Comparative statements also give Comparative statements also give analysts data to perform several analytical analysts data to perform several analytical tests we will examine in Chapter 12.tests we will examine in Chapter 12.

Comparative Financial Comparative Financial StatementsStatements


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End of Chapter 10