understanding the financial aspect

8/12/2019 understanding the financial aspect

1/66

Understanding

Financial StatementsEIGHTH EDITION

Lyn M. Fraser

Aileen Ormiston


2/66

(C) 2007 Prentice Hall, Inc. 2-2

The Balance Sheet

Old accountants never die;they just lose their balance

--Anonymous


3/66


The Balance SheetAlso called the statement of condition or

statement of financial position

Shows the financial condition or financialposition of a company on a

particular date

Financial Condition


4/66


Financial Condition (cont.)

Assets =What the firm owns

Liabilities = What the firm owesto outsiders

Stockholders equity =What the firm owesto

Internal owners

Liabilities + Stockholders equity

Assets =


5/66


General Parameters Consolidationwhen financial

statements are combined due toparent owning more than 50% ofvoting stock in subsidiary

Balance Sheet Date prepared at a point in time/on a particular

date at end of accounting period end of accounting period date can becalendar year or fiscal year or interimperiod such as year, quarter, etc.


6/66


General Parameters (cont.) Comparative Data

SEC requires that Balance Sheet

includes two years of data (current andprior year balances)

Provides reference point fordetermining changes in financialposition over time


7/66


General Parameters (cont.) Common-Size balance sheet useful tool for analyzing the balance

sheet expresses each item on the balance

sheet as a percentage of total assets form of vertical ratio analysis that

allows comparison of firms regardless

of size useful for evaluating trends within a

firm and to make industry comparisons


8/66


Common-Size balance sheet (cont.)Comparison of two major retail companies*

Comparison using $ ($ are in millions):Retailer A Retailer B

Cash $ 5,488 $ 2,245

A/R 1,715 5,069Inventories 29,447 5,384Current Assets 38,491 13,922PPE, net 65,408 16,860

Total Assets 120,223 32,293

*Data from SEC website, www.sec.gov
http://www.sec.gov/http://www.sec.gov/


9/66


Common-Size balance sheet(cont.)Comparison of two major retail companies*

Comparison using common size balance sheet %:Retailer A Retailer B

Cash 4.56 6.95

A/R 1.43 15.70Inventories 24.49 16.67Current Assets 32.02 43.11PPE, net 54.41 52.21



10/66


AssetsGenerally presented in order of liquidity

Common Balance Sheet Accounts/Groupings Current Assets

Cash and Marketable Securities Accounts Receivable Inventories

Prepaid Expenses Long-Term Assets

Property, Plant, and Equipment Other Assets


11/66


A Few DefinitionsCurrent Assets-Cash or other assets

expected to be converted into cash

within one year or one operatingcycle, whichever is longer

OperatingCycle-Time required to

purchase or manufacture inventory,sell the product, and collect thecash


12/66


A Few Definitions (cont.)

Working Capital(Net working capital)

designates the amount by whichcurrent assets exceed currentliabilities


13/66


Cash

and Marketable SecuritiesTwo accounts are often combined asCash and Cash Equivalents

Cash in any formcash awaiting depositor in a bank account

Generally includes currency, coin,balances in checking and other demandor near demand accounts

Cash


14/66


Cash

and Marketable Securities (cont.) Also called short-term investments

Are cash substitutes Represent cash not needed

immediately in the business

Temporarily invested to earn a return

Have short-term maturities

May include T-bills, certificates, notes,bonds, CDs and commercial paper

Marketable Securities


15/66


Statement of Financial

Accounting Standards No. 115Effective for fiscal years beginning after

December 15, 1993

Requires the separation of investmentsecurities into three categories:

1. Held to maturity

2. Trading securities

3. Securities available for sale


16/66


Statement of FinancialAccounting Standards No. 115 (cont.)

Applies to debt securities that the firmhas the positive intent and ability tohold to maturity

Reported at amortized cost

Held to Maturity


17/66



Debt and equity securities that are heldfor resale in the short term

Reported at fair value with unrealizedgains and losses included inearnings

Trading Securities


18/66



Debt and equity securities that are notclassified as one of the other twocategories

Reported at fair value with unrealizedgains or losses included incomprehensive income

Securities Available for Sale


19/66



Does not apply to investments in

consolidated subsidiaries nor toinvestments in equity securitiesaccounted for under the equity

method


20/66


Accounts ReceivableArise from sales transactions to customers

on credit

Reported on the balance sheet at

NET REALIZABLE VALUE

- Allowance for Doubtful Accounts

Net Realizable Value = Accounts Receivable


21/66


A Word on the Allowance Management must estimate the dollar

amount of accounts receivable theyexpect to be uncollectible

Affects balance sheet valuation AND baddebt expense on income statement

Can be important in assessing earningsquality--changes should be analyzed


22/66


Inventories

Items held for sale or used in the

manufacture of products that will besold


23/66


Inventories (cont.)Retail Company

One type of inventory: Finished goods

Manufacturing Company

Three types of inventories:

Raw materials Work-in-process

Finished goods


24/66


Inventories (cont.)Accounting method chosen to value

inventory and the associated

measurement of cost of goods soldhave a considerable impact on acompanys financial position and

operating results


25/66


Inventory

Accounting MethodsInventory valuation is based on an

assumptionregarding the flow of

goodsHas nothing to do with the actualorder

in which products are sold

Cost flow assumption made in order tomatch the cost of products sold tothe revenue generated


26/66


Inventory

Accounting Methods (cont.)Three cost flow assumptions:

FIFO(First In, First Out)

LIFO(Last In, First Out)

Average cost


27/66


Inventory

Accounting Methods (cont.)

Accounting Method

FIFO

LIFO

Average Cost

Cost of Goods Sold

(Income Statement)

first purchases

last purchases(close to current cost)

average of all purchases

Inventory Valuation

(Balance Sheet)

last purchases(close to current cost)

first purchases

average of all purchases


28/66


Inventory


Produces the highest COGS expense andthe lowest ending inventoryvaluation

Matches current costs to current sales

LIFO During Inflation


29/66


Inventory


Produces the lowest COGS expense andthe highest ending inventoryvaluation

Values ending inventory at current cost

FIFO During Inflation


30/66


Inventory

Accounting Methods(cont.)

Inventory valuation may significantly affectBOTH the balance sheet and the incomestatement

Disclosure of inventory cost flow assumptionfound in notes

Inventory reported on balance sheet atLOWER OF COST OR MARKET


31/66


Prepaid ExpensesRepresent expenses paid in advance--

included in current assets if they expirewithin one year or one operating cycle

Usually not a material item

Present few or no reporting or valuation issues


32/66


Property, Plant,

and Equipment (PP&E)Encompasses a companys fixed assets Also called tangible, long-lived, and capital

assets

Fixed assets other than land aredepreciated over the period of timethey benefit the firm

process of depreciation is method ofallocating the cost of long-lived assets


33/66


Property, Plant,

and Equipment (PP&E)(cont.)

On any balance sheet date, PP&E is

shown at BOOK VALUE

Book value = original cost

- accumulated depreciation to date


34/66


Property, Plant,


Straight line spreads the expense

evenly by periods Accelerated yields higher depreciation

expense in the early years of an assetsuseful life, and lower depreciation

expense in the later years Units of production bases depreciation

expense for a given period on actual use

Depreciation methods:


35/66


Property, Plant,


Proportion of fixed assets (PP&E) in acompanys asset structure determined

by nature of the business

Comparisons between firms can be difficult

due to different depreciation methodsand estimates


36/66


Other AssetsCan include multitude of other

noncurrent items such as: Property held for sale Start-up costs in connection with a new

business Cash surrender value of life insurance

policies

Long-term advance payments Long-term investments Intangible assets


37/66


Other AssetsIntangible

Most important for analytical purposes

because of potential materiality

Arises when one company acquiresanother company for a price inexcess of the fair market value ofthe net identifiable assets acquired

Goodwill


38/66


Goodwill(cont.)

Beginning in 2002, companies requiredto evaluate goodwill and determine

whether it has lost value

Amount of impairment is expensed in

the year the determination is made


39/66


Goodwill(cont.)

Some corporations take enormous

write-offs when companies they

have acquired lose value

Earnings increase for some firms relative

to prior years because amortizationexpense is no longer recorded


40/66


Goodwill(cont.)

Companies have some discretion indeciding when and how much

write-off to take as a result ofgoodwill impairment

Goodwill


41/66


Goodwill (cont.)

($ in millions)

Year GW Impairment GW Amortization

2005 $ 24 $ ----

2004 10 ----

2003 318 ----

2002 44,039 ----2001 ---- 6,366


Example of the impact the 2002 change forgoodwill expense had on a major entertainmentcompany over a 5 year period *


42/66


LiabilitiesRepresent claims against assets by creditors

Current Liabilities must be satisfied in oneyear or one operating cycle and include:

Accounts Payable Notes Payable Current Portion of Long-Term Debt

Accrued Liabilities Unearned Revenue Deferred Taxes


43/66


Liabilities(cont.)

Short-term obligations that arise from

credit extended by suppliers for thepurchase of goods and services Account is eliminated when the bill is

satisfied

Significant changes from period to periodoften result from changes in sales volume,economic conditions or credit policiesavailable to firm from its suppliers

Accounts Payable


44/66


Liabilities(cont.)

Short-term obligations in the formof promissory notes and/or lines ofcredit to suppliers or financial

institutions

Notes Payable


45/66


Liabilities(cont.)

When a firm has bonds, mortgages, orother forms of long-term debtoutstanding, the portion of theprincipal that will be repaid duringthe upcoming year is classified as acurrent liability

Current Maturities of Long-Term Debt


46/66


Liabilities (cont.)

Result from recognition of expensesbefore they are actually paid

Under accrual accounting, expenses arerecognized when INCURRED and thus

ACCRUED, not when paid in cash In this case, cash flow succeeds expenserecognition

Accrued Liabilities


47/66


Liabilities (cont.)

Result from prepayments received inadvance for services or products

Under accrual accounting, revenue isrecognized when EARNED, not when

cash is received In this case, cash flow precedes revenue

recognition

Unearned Revenue or Deferred Credits


48/66


Liabilities (cont.)

Result of temporary differences in therecognition of revenue and expensefor taxable income relative toreported financial income

Deferred Federal Income Taxes


49/66


Deferred Federal IncomeTaxes (cont.)

Objective is to take advantage of allavailable tax deferrals in order to

reduce actual tax payments, whileshowing the highest possibleamount of reported net income


50/66


Deferred Federal IncomeTaxes (cont.)

When the total amount of expense andrevenue recognized will eventuallybe the same for tax and financialreporting purposes

Temporary Differences/Timing Differences


51/66


Deferred Federal Income

Taxes(cont.)

Do not affect deferred taxes because atax will never be paid on the incomeor the expense will never bededucted on the tax return

Permanent Differences


52/66


Noncurrent Liabilities

Long-Term Debt

Capital Lease Obligations

Postretirement Benefits Other ThanPensions

Commitments and Contingencies

Hybrid Securities

Obligations with maturities beyond one year


53/66


Noncurrent Liabilities (cont.)

Bonds

Long-Term Notes Payable

Mortgages

Obligations under leases

Pension Liabilities

Long-Term Warranties

Long-Term Debt


54/66



Are, in substance, a purchaserather than a lease

Affect both balance sheet and

income statement

Capital Lease Obligations


55/66



Can appear under the liability section of

the balance sheet Can have a significant impact on

corporate balance sheets

Can also impact profitability bysubstantially increasing the recognition ofannual postretirement benefit expense

Postretirement benefits Other Than Pensions


56/66



Intended to draw attention to the factthat required disclosures can befound in the notes to the financial

statements

Commitments and Contingencies


57/66


58/66



Refer to potential liabilities of the firmsuch as possible damage awardsassessed in lawsuits

Contingencies


59/66



Have the characteristics of both debtand equity

Some companies havemandatorily redeemable preferredstock outstanding

Hybrid Securities

For example:


60/66


Stockholders Equity

Ownership equity is the residual interest

in assets that remains afterdeducting liabilities


61/66


Stockholders Equity (cont.)

Shareholders:

Do not ordinarily receive a fixed return

Have voting privileges in proportion to ownershipinterest

Dividends are declared at the discretion of acompanys board of directors

Common Stock


62/66



Reflects the amount by which theoriginal sales price of the stockshares exceeded par value

Additional Paid-In Capital


63/66


64/66



Other accounts that can appear in theequity section include:

Preferred stock

Accumulated other comprehensive income

Treasury stock

Other Equity Accounts


65/66


Other Balance Sheet Items

Corporate balance sheets are not limited tothe accounts described in this chapter

The reader of annual reports will encounteradditional accounts and will also find

many of the same accounts listed undera variety of different titles

Th J


66/66

The JourneyThrough the Maze Continues

Ch. 3: Income Statement andStatement of Stockholders Equity

Ch. 4: Statement of Cash Flows

Ch. 5: A Guide to Earnings and Financial

Reporting QualityCh. 6: The Analysis of Financial

Statements

understanding the financial aspect

Documents