The Balance Sheet and Financial Disclosu

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The Balance Sheet and Financial Disclosures : 

The Balance Sheet and Financial Disclosures

Objectives of the Chapter : 

The Balance Sheet and Financial Disclosures 2 Objectives of the Chapter 1. Identify the major classifications of the balance sheet. 2. Prepare a classified balance sheet statement. 3. Discuss the disclosures to financial statements.

Objectives of the Chapter (contd.) : 

The Balance Sheet and Financial Disclosures 3 Objectives of the Chapter (contd.) 4. Understand the accounting treatment for subsequent events. 5. Use financial ratios to study financial performance of corporations. 6. Limitations of B/S.

Balance Sheet Statement and Statement of Cash Flows : 

The Balance Sheet and Financial Disclosures 4 Balance Sheet Statement and Statement of Cash Flows Balance Sheet: Providing information about the financial position of a business entity at a given point in time (i.e., on December 31). Also providing information about the liquidity, financial flexibility and operating capability of a business entity. Statement of Cash Flows: Providing uses and sources of cash and financial and investing information of a business entity.

Exhibit 5-1 : 

The Balance Sheet and Financial Disclosures 5 Exhibit 5-1 Scientific Products, Inc. BALANCE SHEET December 31, 1998 Assets Current assets Cash $42,485 Available-for-sale securities--at fair value 28,250 Accounts receivable $165,824 Less allow. for doub. Accts. 1,850 163,974 Notes receivable 23,000 Inventories -- at average cost 489,713 Supplies on hand 9,780 Prepaid expenses 16,252 5

Exhibit 5-1 (contd.) : 

The Balance Sheet and Financial Disclosures 6 Exhibit 5-1 (contd.) Scientific Products, Inc. BALANCE SHEET December 31, 1998 Prepaid expenses 16,252 Total current assets $773,454 Long-term investments Investments in Warren Co. 87,500 Property, plant, and equipment Land--at cost 125,000 Buildings--at cost 975,800 Less accu. Depr. 341,200 634,600 Total PPE 759,600 Intangible assets Goodwill 100,000 Total assets $1,720,554 6

Exhibit 5-1 (contd.) : 

The Balance Sheet and Financial Disclosures 7 Exhibit 5-1 (contd.) Liabilities and Stockholders’ Equity Current liabilities N/P to banks $50,000 Accounts payable 197,532 Accrued int. on N/P 500 Income taxes payable 62,520 Accrued salaries, wages, and other liabilities 9,500 Deposits received from customers 420 Total current liabilities $320,472 Long-term debt 20-year 12% debentures, due January 1, 2008 500,000 Total liabilities 820,472 7

Exhibit 5-1 (contd.) : 

The Balance Sheet and Financial Disclosures 8 Exhibit 5-1 (contd.) Stockholders’ equity Paid in on capital stock Preferred, 7%, cumulative Authorized, issued, and outstanding, 30,000 shares of $10 par value $300,000 Common-- Authorized, 500,000 shares of $1 par value; issued & outstanding, 400,000 shares 400,000 additional paid-in capital 37,500 737,500 Earnings retained in the business 162,582 Total stockholders’ equity 900,082 Total liabilities and stockholders’ equity $1,720,554 8

Exhibit 5-2 : 

The Balance Sheet and Financial Disclosures 9 Exhibit 5-2 Nestor Company STATEMENT OF CASH FLOWS For the Year Ended December 31, 1999 Cash flows from operating activities Net income $320,750 Adj. to reconcile net income to net cash provided by operating activities: Depreciation expense $88,400 Amortization of intangibles 16,300 Gain on sale of plant assets (8,700) Increase in A/R (net) (11,000) Decrease in inventory 15,500 Decrease in accounts payable (9,500) 91,000 Net cash provided by operating activities 411,750 9

Exhibit 5-2 (contd.) : 

The Balance Sheet and Financial Disclosures 10 Exhibit 5-2 (contd.) Net cash provided by operating activities 411,750 Cash flows from investing activities Sale of plant assets 90,500 Purchase of equipment (182,500) Purchase of land (70,000) Net cash used by investing activities (162,000) Cash flows from financing activities Payment of cash dividend (19,800) Issuance of common stock 100,000 Redemption of bonds (50,000) Net cash provided by financing activities 30,200 Net increase in cash 279,950 Cash at beginning of year 135,000 Cash at end of year $414,950 10

Definition of Elements of a Balance Sheet: (SFAC No. 6) : 

The Balance Sheet and Financial Disclosures 11 Definition of Elements of a Balance Sheet: (SFAC No. 6) Assets Liabilities Stockholders’ equity

Assets : 

The Balance Sheet and Financial Disclosures 12 Assets Resources with future economic benefit to a business entity as a result of a past transaction.

Assets (contd.) : 

The Balance Sheet and Financial Disclosures 13 Assets (contd.) a. Current Assets: cash and other assets that are reasonably expected to be realized in cash or sold, or consumed during a normal operating cycle or one year, whichever is longer (i.e., cash, A/R, inventory, prepaid expenses…). b. Investments: Land or building held for future use; securities held as long-term investments.

Assets (contd.) : 

The Balance Sheet and Financial Disclosures 14 Assets (contd.) c. Property, Plant, Equipment: assets used in firms’ operations and meet the following criteria: 1. Economic life > 1 year; 2. Acquired for use in operation; 3. Not for resale to customers; 4. $ is material. (materiality) Depreciation will be applied.

Assets (contd.) : 

The Balance Sheet and Financial Disclosures 15 Assets (contd.) d. Intangible Assets: assets with no physical substance but have value based on rights or privileges that belong to the owner (i.e., patents, franchises, trademarks,…). e. Other Assets: deferred charges (long-term prepayments).

Liabilities : 

The Balance Sheet and Financial Disclosures 16 Liabilities Legal obligations required future payments of assets or services as a result of a business entity’s past transactions or events. A. Current Liabilities B. Long-term Liabilities C. Other Liabilities

A. Current Liabilities : 

The Balance Sheet and Financial Disclosures 17 A. Current Liabilities Obligations must be fulfilled in one year or one operating cycle, whichever is longer. (will require the use of current assets or the creation of current liability) (i.e., A/P, N/P, wages payable,…)

Contingencies : 

The Balance Sheet and Financial Disclosures 18 Contingencies Contingent Liabilities Contingent Losses Contingent Gains

Contingent Liabilities : 

The Balance Sheet and Financial Disclosures 19 Contingent Liabilities Obligations may arise because of the occurrence or not occurrence of future event(s). (i.e., warranty obligations)

Contingent Losses : 

The Balance Sheet and Financial Disclosures 20 Contingent Losses Losses may arise because of the occurrence or not occurrence of future event(s). (i.e., the uncollectable accounts, the pending lawsuit losses, possible damage of a fire (or flood)…)

Contingent Gains : 

The Balance Sheet and Financial Disclosures 21 Contingent Gains Gains may arise because of the occurrence or not occurrence of future events). (i.e., pending lawsuit gains)

Accounting Treatments of Contingencies : 

The Balance Sheet and Financial Disclosures 22 Accounting Treatments of Contingencies The accounting treatments of the contingencies depend on the occurrence probability of the related future event(s).

Accounting Treatments of Contingencies (contd.) : 

The Balance Sheet and Financial Disclosures 23 Accounting Treatments of Contingencies (contd.) Occurrence probabilities of future event(s): (SFAS No. 5) 1. Probable: The future event(s) is(are) likely to occur. 2. Reasonably possible: The chance for the future event(s) to occur is less than probable but greater than remote. 3. Remote: The chance of the future event to occur is unlikely.

Accounting Treatments of Contingent Liabilities & Losses : 

The Balance Sheet and Financial Disclosures 24 Accounting Treatments of Contingent Liabilities & Losses If the future event(s) is(are) a. probable, and b. amount of loss (liability) can be estimated -- The loss (liability) should be estimated, and recognized (accrued).

Examples : 

The Balance Sheet and Financial Disclosures 25 Examples 1. B/D Exp. XXX Allowance for B/D XXX 2. Warranty Exp. XXX Estimated Warranty Liabilities XXX 3. Lawsuit Exp. XXX Estimated Liability under Litigation XXX

Accounting Treatments of Contingent Liabilities & Losses (contd.) : 

The Balance Sheet and Financial Disclosures 26 Accounting Treatments of Contingent Liabilities & Losses (contd.) If the future event is probable, but the amount of loss (or liability) CANNOT be estimated, the contingent loss (or liability) should only be footnoted (not accrued).

Accounting Treatments of Contingent Gains : 

The Balance Sheet and Financial Disclosures 27 Accounting Treatments of Contingent Gains If the event is probable and the amount of contingent gains is determinable, only footnote the information. NO unrealized gain can be recognized under the current accounting standards (conservatism!).

B. Long-Term Liabilities : 

The Balance Sheet and Financial Disclosures 28 B. Long-Term Liabilities Obligations are not due in next year or next operating cycle, whichever is longer. (i.e., B/P, mortgage payable,…)

C. Other Liabilities : 

The Balance Sheet and Financial Disclosures 29 C. Other Liabilities Long-term advances from customers, deferred income taxes.

Stockholders’ Equity : 

The Balance Sheet and Financial Disclosures 30 Stockholders’ Equity Residual claims (assets-liabilities) to the business entity from stockholders including: a. contributed capital + or - b. unrealized capital + c. retained earnings (or - deficit) (-) d. treasury stock

a. Contributed Capital (Legal Capital) : 

The Balance Sheet and Financial Disclosures 31 a. Contributed Capital (Legal Capital) Par value of common stock Par value of prefer stock Paid-in capital in excess of par value of common stock or preferred stock

b. Unrealized Capital : 

The Balance Sheet and Financial Disclosures 32 b. Unrealized Capital Increase of assets without outflows of assets, increase of liabilities, increase of income or issuance of common stock (i.e.,(+) increase in market value of securities-available-for-sale (-) any excess of additional pension liability over prior service cost(+ or -) foreign currency adjustment gain or loss,etc.)

c. Retained Earnings : 

The Balance Sheet and Financial Disclosures 33 c. Retained Earnings Net income not distributed to stockholders appropriated unappropriated

Other Disclosure Issues : 

The Balance Sheet and Financial Disclosures 34 Other Disclosure Issues APB opinion No. 22 required disclose the following information as an integral part of the financial statement (i.e., in the footnote): 1. Accounting Policies: depreciation method of PPE, inventory cost flow method and valuation method (LCM), revenue recognition principles. 2. Contingent Liabilities & Assets. 3. Subsequent Events.

SEC Regulations : 

The Balance Sheet and Financial Disclosures 35 SEC Regulations Publicly traded firms need to file the 10-K report with the SEC. Some of the SEC regulations for the 10-K report are also followed by the firms in preparing the annual report.

Example A : 

The Balance Sheet and Financial Disclosures 36 Example A Comparative financial statements B/S ? 2 years I/S and cash flow statement ? 3 years Selected financial data items (i.e., net sales, operating revenue EPS, total assets, cash dividends declared) should have a 5-year data.

Example B : 

The Balance Sheet and Financial Disclosures 37 Example B Management Discussion Any information useful in assessing cash flows but not in the B/S (i.e. inflation impact on sales, liquidity and capital resources of the firm,…) should be included in the management discussion.

Example C : 

The Balance Sheet and Financial Disclosures 38 Example C Market Prices and Dividends of Common Stocks: The high and low prices for each quarter in the last two years. The dividends paid in the last two years.

Example D : 

The Balance Sheet and Financial Disclosures 39 Example D Other Information: Employee stock options, pension and insurance plans, long-term leases, purchase commitment, bond covenants, notes receivable, etc.

Subsequent Event : 

The Balance Sheet and Financial Disclosures 40 Subsequent Event Significant events occurred after the fiscal year end but before the issuance date of the annual report.

Subsequent Event - Introduction : 

The Balance Sheet and Financial Disclosures 41 Subsequent Event - Introduction Investors should be informed of significant events such as mergers, acquisitions, break-ups, spin-offs, issuance of bonds, issuance of stocks, settlement of litigation, loss of plant due to flood or fire even if these events occur after the fiscal year end. As long as these events occur prior to the issuance date of the annual reports, they should be disclosed in the reports.

Subsequent Event - Overview : 

The Balance Sheet and Financial Disclosures 42 Subsequent Event - Overview There are two types of subsequent events: 1. Events require adjustments of balance sheet statement. 2. Events do not require adjustment of balance sheet statement but require disclosure in the footnotes.

Events Require Adjustment of B/S : 

The Balance Sheet and Financial Disclosures 43 Events Require Adjustment of B/S Events with evidence indicates that conditions existed at or prior to the B/ S date. Examples: (assume FYE is 12/31/x1 and the report release date is 3/31/x2) Bankruptcy occurred on a major client on 2/1/x2. The bankruptcy condition may exist for this client prior to 12/31/x1. Litigation settlement on 2/10/x2. The condition for this litigation existed prior to 12/31/x1.

Events Do Not Require Adjustment of B/S but Require Disclosure : 

The Balance Sheet and Financial Disclosures 44 Events Do Not Require Adjustment of B/S but Require Disclosure Examples: (assume FYE is 12/31/x1 and the report release date is 3/31/x2) A fire occurred on a major client on 3/1/x2. Sales of bonds on 2/9/x2. Loss of inventories due to a fire on 1/20/x2. Issuance of common stock on 1/30/x2.

Ratio Analysis : 

The Balance Sheet and Financial Disclosures 45 Ratio Analysis Ratio analysis is one of the techniques that financial analysts use to analyze the financial statements of firms. For the purpose of analyzing financial statements, ratios can be classified into the following four categories: (see Exhibit 5-3)

Exhibit 5-3 : 

The Balance Sheet and Financial Disclosures 46 Exhibit 5-3 Major Types of Ratios Liquidity Ratios. Measures of the enterprise’s short-term ability to pay its maturing obligations. Activity Ratios. Measures of how effectively the enterprise is using the assets employed. Profitability Ratios. Measures of the degree of success or failure of a given enterprise or division for a given period of time. (Stability Ratios.) Coverage Ratios. Measures of the degree of protection for long-term creditors and investors.

Exhibit 5-4 : 

The Balance Sheet and Financial Disclosures 47 Exhibit 5-4 Ratio I. Liquidity 1.Current ratio 2.Quick or acid-test ratio 3.Current cash debt coverage ratio Purpose or Use Measures short-term debt-paying ability Measures immediate short-term liquidity Measures a company’s ability to pay off its current liabilities in a given year from its operations Formula Current assets Current liabilities Cash, marketable securities, and receivables (net) Current liabilities Net cash provided by operating activities Average current liabilities

Exhibit 5-4 (contd.) : 

The Balance Sheet and Financial Disclosures 48 Exhibit 5-4 (contd.) Ratio II. Activity 4.Receivable turnover 5.Inventory turnover 6.Asset turnover III. Profitability 7.Profit margin on sales Purpose or Use Measures liquidity of receivables Measures liquidity of inventory Measures how efficiently assets are used to generate sales Measures net income generated by each dollar of sales Formula Net Credit Sales Average trade receivables (net) Cost of goods sold Average inventory Net Sales Average total assets Net income Net sales 48

Exhibit 5-4 (contd.) : 

The Balance Sheet and Financial Disclosures 49 Exhibit 5-4 (contd.) Ratio III. Profitability(contd.) 8.Rate of return on assets 9.Rate of return on common stock equity 10.Earnings per share 11.Price earnings ratio Purpose or Use Measures overall profitability of assets Measures profitability of owners’ investment Measures net income earned on each share of common stock Measures the ratio of the market price per share to earnings per share Formula Net income Average total assets Net income minus preferred dividends Average common stockholders’ equity Net income minus preferred dividends Weighted shares outstanding Market price of stock Earnings per share 49

Exhibit 5-4 (contd.) : 

The Balance Sheet and Financial Disclosures 50 Exhibit 5-4 (contd.) Ratio III. Profitability(contd.) 12.Payout ratio IV. Coverage (Stability Ratios) 13.Debt to total assets 14.Time interest earned Purpose or Use Measures % of earnings distributed in the form of cash dividends Measures the % of total assets provided by creditors Measures ability to meet interest payments as they come due Formula Cash dividends Net income Total debt Total assets or equities Income before int. charges & taxes Interest charges 50

Exhibit 5-4 (contd.) : 

The Balance Sheet and Financial Disclosures 51 Exhibit 5-4 (contd.) Ratio IV. Coverage(contd.) 15.Cash debt coverage ratio 16. Book value per share Purpose or Use Measures a company’s ability to repay its total liabilities in a given year from its operations Measures the amount each share would receive if the company were liquidated at the amounts reported on the balance sheet Formula Net cash provided by operating activities Average total liabilities Common Stockholders’ equity Outstanding shares 51