UNDERSTANDING FINANCIAL STATEMENTS

BALANCE SHEET (Chapter 2) Assets

BALANCE SHEET A “statement of financial condition” On a particular date (a “snapshot”) OBJECTIVES:

a fundamental understanding of accounts described on a balance sheet

a feel for the relationship of each account to the financial statements as a whole

The Basic EquationASSETS = LIABLITIES + STOCKHOLDERS’

EQUITY

ASSETS are economic resources owned by the firm

LIABILITIES are what the firm owes to outsiders

EQUITIES are what the firm owes to insiders

Some General Parameters Financial statements are often

CONSOLIDATED(when a company owns more than 50% of another company, then % of assets, liabilities, and SE of the subsidiary company are added to the parent company’s balance sheet)

Balance sheet is DATED on a specific day: at end of accounting period (calendar year or fiscal

year) at end of interim period (i.e., month or quarter)

COMPARATIVE (e.g. balances for end of previous year shown on

current balance sheet)

Common size balance sheet

A tool for analyzing the balance sheet. Used to facilitate structural analysis of a firm,

evaluate trends, and make industrial comparisons. Expresses each item on balance sheet as a

percentage of total assets or equities. See exhibit 2-1

ASSETS Assets – probable future economic benefits

obtained or controlled by a particular entity as a result of past transactions or events.

“probable economic benefits” must be objectively measured.

The following are Not Assets: research and development costs internally developed intangible assets

(internally developed goodwill, internally developed Tradenames, knowledge capital)

ASSETS Generally presented in order of liquidity Current Assets -- defined as cash or assets expected

to be converted to cash within one year or operating cycle, whichever is longer operating cycle is time required to

purchase/manufacture the inventory, sell it and collect the cash

Noncurrent Assets -- defined as assets expected to be converted to cash after the completion of one year or one operating cycle, whichever is longer

Current Assets Cash and cash equivalents Marketable Securities (short-term) Accounts Receivable Notes Receivable (short-term) Inventory Prepaid Expenses

Noncurrent Assets(aka Long-termAssets)

Long-term Investments Property, Plant and Equipment

less accumulated depreciation Intangible Assets

less accumulated amortization “Other” Assets

Cash and Cash Equivalents

The most liquid of assets Generally includes currency, coin, balances in

checking and other demand or “near demand” accounts

Cash equivalents include investments with an original maturity date of less than 90 days

Marketable Securities Held to Maturity securities – debt securities

(bonds) that management intends to hold to maturity.

Reported at amortized cost.

Usually reported in Long-term Investments, unless they mature within the subsequent yr.

Marketable Securities Short-term investments that the firm INTENDS

to hold for less than one year (thus a “current” asset)

Generally reported on balance sheet at market value

May include t-bills, stocks (equity securities), bonds (debt securities), CDs (with an original maturity date of 90 days or more)

Marketable Securities Trading securities are debt securities (bonds) and

equity securities (stocks) that are held for resale in the short term. These securities are reported at fair value on BS. The unrealized gains and losses are shown on the Income

Statement under “Other Income/Expenses” as well as gains and losses from current year sale of the securities.

Marketable Securities Available for sale securities are debt securities

(bonds) and equity securities (stocks) that are not held to maturity securities nor trading securities. These securities are reported at fair value on BS. Some may be in Current Assets & some in LT

Investments depending on mgmt’s intent on sale date.

The unrealized gains and losses for the current year are included in Comprehensive Income not in IS.

The cumulative net unrealized gains or losses at the end of the year are reported in the Accumulated Other Comprehensive Income account in the Stockholders’ Equity section of the BS.

The gains and losses from current year sale of the securities are shown on the Income Statement.

Accounts Receivable Arise from credit-sale transactions Reported on balance sheet at NET REALIZABLE

VALUE Accounts Receivable $$$ Less Allowance for Doubtful Accounts $$$ Net Accounts Receivable $$$

Direct write-off method is not in conformity with GAAP, it violates the matching principle and does not report A/R at net realizable value.

The bad debt expense would be in a future year, not in the current year.

Allowance for Uncollectible Management must estimate the dollar amount of

accounts they expect to be uncollectible (most companies use aged accounts receivable method)

Affects balance sheet valuation AND bad debt expense on income statement

Can be important in assessing earnings quality -- changes should be analyzed (i.e., increase in allowance for uncollectible account should be similar to increase in the accounts receivable balance and to increase in sales)

Inventory Consist of items held for sale or used in

manufacture of goods for sale Merchandising Company

one type of inventory (finished goods)

Manufacturing Company three types of inventories (raw materials, work-

in-process, finished goods)

Often firm’s major revenue producer

Inventory Issues Valuation method (must be disclosed)

FIFO (first-in, first-out) LIFO (last-in, first-out) Average Cost Specific identification

Inventory valuations significantly affects both the balance sheet and the income statement

Disclosure of inventory cost flow assumption found on face of balance sheet or in notes

If LIFO is used, then co. can disclose the increase of income and inventory balance using FIFO

US federal tax code requires use of LIFO for financial statements if LIFO is used for tax return

Inventory methods

First purchases

(lower costs,

lower inven. balance)

Last purchases (higher costs, lower net income, lower taxes) (close to current cost)

LIFO

Last purchases (higher costs, higher inventory balance) (close to current cost)

First purchases (lower costs, higher net income, higher taxes)

FIFO

Inventory Balance (BS)Cost of Goods Sold (IS)Acctg Method

Inventory Issues Inventory reported on balance sheet at

LOWER OF COST OR MARKET. When the market value of the ending inventory

declines below cost, then the inventory is revalued at market and a loss should be reported in that year.

Once the inventory has been written down it cannot be written back up.

Prepaid Expenses Represent expenses paid in advance --

included in current assets if they expire within one year or operating cycle

Usually not a material item Few or no reporting or valuation issues Includes prepaid rent and prepaid insurance

Property, Plant & Equipment Often called “fixed assets” and “capital assets” Represent major resource commitments which benefit a

firm for more than one year Proportion of fixed assets (PP&E) in a firm’s asset

structure determined by nature of the business Recorded at HISTORICAL cost Historical Cost is reduced by Accumulated Depreciation.

Cost is allocated over asset’s useful life through DEPRECIATION (exception: land is not depreciated)

PPE: Cost Issues PPE is reported on balance sheet at historical cost less

accumulated depreciation-to-date Reliable, but not representative of market value

Capitalize (include in cost on BS) all costs incurred to get the asset ready for its intended use.

purchase price + sales tax + freight + installation costs + repairs needed upfront + later repairs/improvements which increase productivity or useful life

(other repairs are expensed in IS in year incurred)

PPE: Depreciation Issues Depreciation process involves ESTIMATES

(useful life and residual value) Depreciation process involves choice of

depreciation method (accelerated, straight-line methods)

Comparison among firms can be made difficult with different methods and different estimates

Intangible Assets Resources with expected future economic benefits but

lacking a physical substance Some examples are patents, copyrights, franchises,

trademarks, goodwill, organization costs in connection with a new business

Internally developed intangible assets are not recorded. Intangible Assets are amortized (except for goodwill after

2001), usually using straight-line method. Life should be the shorter of:

1. the useful life;2. the asset’s legal or contractual life;3. practical considerations (life used for tax return) or4. 40 years.

Intangible Assets Patents - provide the holder exclusive rights to use,

manufacture, or sell a product or process.1. the legal life is 17 years.2. for internally developed patents only capitalize any legal costs, the rest of the costs are considered Research and Development Costs which are expensed in the year incurred and not capitalized.

Copyrights - copyrights refer to exclusive rights over musical or artistic works.1. the legal life is the life of the creator plus 50 years. So life used for amort. is usually 40 years.

Intangible Assets Trademarks - a word, phrase, or symbol that identifies

an enterprise or product. Capitalized costs are only legal costs and the value of trademarks purchased from a third party.The legal life is 20 years, but the exclusive right is renewable indefinitely, therefore 40 years should be used.

Goodwill - represents the amount paid for another company in excess of the fair market value of the purchased assets less any liabilities assumed. Do not capitalize internally developed goodwill.Most companies use 40 years for life prior to 2002, goodwill is not amortized after 2001.

Long-term Investments

Investments and Funds that management does not intend to sell or use within the subsequent year. Marketable equity and debt securities:

Available-for sale securities (recorded at fair value)Held-to-maturity securities (recorded at amortized cost)

Stock in a privately held company (recorded at cost) Property held for investment (recorded at cost) Plant, property or equipment held for sale or not

currently used in operations (recorded at undeprec.cost)

Cash surrender value of life insurance policies Restricted cash accounts (i.e., bond sinking fund)

Other Assets(deemed long-term)

Long term advance payments (prepaid rent and prepaid insurance)

Bond issuance costs