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CHAPTER5

BalanceSheetandStatementof CashFlows

ASSIGNMENTCLASSIFICATIONTABLE(BY TOPIC)
Topics
1. Disclosure principles, uses and limitations of the balance sheet, financial flexibility. Classification of items in the balance sheet and other financial statements. Questions 1, 2, 3, 4, 5, 6, 7, 10, 18, 20, 26, 29, 30, 31 11, 12, 13, 14, 15, 16, 17, 18, 19 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11 1, 2, 3, 4, 5, 6, 7, 8, 9, 10 5, 6, 7, 11, 12, 17 1, 2, 3, 4, 5, 6, 7 Brief Exercises Exercises Problems 6, 7 Conceptsfor Analysis 4, 5

2.

1, 2, 3

3.

Preparation of balance 6, 9, 15, 16, sheet; issues of 17, 29, 32 format, terminology, and valuation. Statement of cash flows. 21, 22, 23, 24, 25, 27, 28 12, 13, 14, 15, 16

3, 4

4.

13, 14, 15, 16, 17, 18

6, 7

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ASSIGNMENTCLASSIFICATIONTABLE(BY LEARNINGOBJECTIVE)
Brief Exercises

LearningObjectives
1. 2. 3. Explain the uses and limitations of a balance sheet. Identify the major classifications of the balance sheet. Prepare a classified balance sheet using the report and account formats. Indicate the purpose of the statement of cash flows. Identify the content of the statement of cash flows. Prepare a basic statement of cash flows. Understand the usefulness of the statement of cash flows. Determine which balance sheet information requires supplemental disclosure. Describe the major disclosure techniques for the balance sheet.

Exercises

Problems
6, 7

1, 2, 3, 4, 6, 8, 9 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11 1, 2, 3, 4, 5, 6, 7, 9, 10, 11, 12, 17 10 13 12, 13, 14, 15 16 14, 15, 16, 17, 18 15, 16, 18 6, 7 6, 7 4 1, 2, 3, 4, 5, 6, 7

4. 5. 6. 7. 8. 9.

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ASSIGNMENTCHARACTERISTICSTABLE
Level of Difficult y Simple Simple Simple Simple Simple Complex Moderate Moderate Complex Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex Complex Complex Complex Time (minute s) 1520 1520 1520 3035 3035 3035 1520 1015 3035 1520 2530 3035 1520 2535 2535 2535 3035 2535 3035 3540 4045 4045 4050 3545 4050

Ite m E5-1 E5-2 E5-3 E5-4 E5-5 E5-6 E5-7 E5-8 E5-9 E5-10 E5-11 E5-12 E5-13 E5-14 E5-15 E5-16 E5-17 E5-18 P5-1 P5-2 P5-3 P5-4 P5-5 P5-6 P5-7

Description

Balance sheet classifications. Classification of balance sheet accounts. Classification of balance sheet accounts. Preparation of a classified balance sheet. Preparation of a corrected balance sheet. Corrections of a balance sheet. Current assets section of the balance sheet. Current vs. long-term liabilities. Current assets and current liabilities. Current liabilities. Balance sheet preparation. Preparation of a balance sheet. Statement of cash flowsclassifications. Preparation of a statement of cash flows. Preparation of a statement of cash flows. Preparation of a statement of cash flows. Preparation of a statement of cash flows and a balance sheet. Preparation of a statement of cash flows, analysis. Preparation of a classified balance sheet, periodic inventory. Balance sheet preparation. Balance sheet adjustment and preparation. Preparation of a corrected balance sheet. Balance sheet adjustment and preparation. Preparation of a statement of cash flows and a balance sheet. Preparation of a statement of cash flows and a balance sheet. Reporting for financial effects of varied transactions. Identifying balance sheet deficiencies. Critique of balance sheet format and content. Presentation of property, plant, and equipment. Cash flow analysis.

CA5-1 CA5-2 CA5-3 CA5-4 CA5-5

Moderate Moderate Simple Simple Complex

2530 2025 2530 2025 4050

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LEARNINGOBJECTIVES
1. 2. 3. 4. 5. 6. 7. 8. 9. *10. *11. Explain the uses and limitations of a balance sheet. Identify the major classifications of the balance sheet. Prepare a classified balance sheet using the report and account formats. Indicate the purpose of the statement of cash flows. Identify the content of the statement of cash flows. Prepare a basic statement of cash flows. Understand the usefulness of the statement of cash flows. Determine which balance sheet information requires supplemental disclosure. Describe the major disclosure techniques for the balance sheet. Identify the major types of financial ratios and what they measure. Compare the accounting procedures related to the balance sheet under GAAP and IFRS.

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CHAPTERREVIEW
*Note:All asterisked (*) items relate to material contained in the Appendix to the chapter. 1. Chapter 5 presents a detailed discussion of the concepts and techniques that underlie the preparation and analysis of the balance sheet. Along with the mechanics of preparation, acceptable disclosure requirements are examined and illustrated. A brief introduction to the statement of cash flows is also presented. This explanation serves as a foundation for the more comprehensive discussion of this subject presented in Chapter 23. At the end of Chapter 5, a multi-page illustration of the financial statements and accompanying notes of a corporation are presented. This illustration may be referred to throughout the study of intermediate accounting as it includes information relevant to many of the topics discussed in subsequent chapters. Usefulnessof the BalanceSheet 2. (L.O. 1)For many years financial statement users generally considered the income statement to be superior to the balance sheet as a basis for judging the economic wellbeing of an enterprise. However, the balance sheet can be a very useful financial statement. If a balance sheet is examined carefully, users can gain a considerable amount of information used to assess liquidity, solvencyand financial flexibility. Liquidity is generally related to the amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid. Solvency refers to the ability of an enterprise to pay its debts as they mature. Financial flexibility is the ability of an enterprise to take effective action to alter the amounts and timing of cash flow so that it can respond to unexpected needs and opportunities. Limitationsof the BalanceSheet 3. Criticism of the balance sheet has revolved around the limitations of the information presented therein. These limitations include: (a) Failure to reflect current value information. (b) The extensive use of judgment and estimates. (c) Failure to include items of financial value that cannot be recorded objectively. 4. The problem with current value information concerns the reliability of such information. The estimation process involved in developing current-value type information causes a concern about the objectivity of the resulting financial information. The use of estimates is extensive in the development of balance sheet data. These estimates are required by generally accepted accounting principles, but reflect a limitation of the balance sheet. The limitation concerns the fact that the estimates are only as good as the understanding and objectivity of the person(s) making the estimates. The final limitation of the balance sheet concerns the fact that some significant assets of the entity are not recorded. Items such as human resources (employee workforce), managerial skills, customer base, and reputation are not recorded because such assets are difficult to quantify.

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Classificationin the BalanceSheet 5. (S.O. 2)The majorclassificationsused in the balance sheet are assets,liabilities,and equity. To provide the financial statement reader with additional information, these major classifications are divided into several subclassifications. Assets are further classified as current or noncurrent, with the noncurrent divided among long-term investments; property, plant, and equipment; intangible assets; and other assets. Liabilities are classified as current or noncurrent. Owners equity includes capital stock, additional paid-in capital, and retained earnings. Assets.Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. 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. 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. CurrentAssets 6. Current assets are 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. Current assets are presented in the balance sheet in the order of their liquidity and normally include cash and cash equivalents, short-term investments, receivables, inventories, and prepaid expenses.There are some exceptions to a literal interpretation of the current asset definition. These exceptions involve prepaid expenses, investments in common stock, and the subsequent years depreciation of fixed assets. These exceptions are recognized in the accounting process and are understood by most financial statement users. ReportingCurrentAssets 7. Any restrictions on the general availability of cash or any commitments on its probable disposition must be disclosed. Short-term investments are usually categorized as held-tomaturity, trading, or available-for-sale. Any anticipated loss due to uncollectibles, the amount and nature of any nontrade receivables, and any receivables designated as collateral should be clearly identified. For a proper presentation of inventories, the basis of valuation (i.e., lower of cost or market) and the method of pricing (FIFO or LIFO) should be disclosed. A company includes prepaid expenses in current assets if it will receive benefits within one year or the operating cycle, whichever is longer.

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LongTermInvestments 8. Items classified as longterm investments in the assets section of the balance sheet normally are one of four types. These include: a. Investments in securities, such as common stock, bonds, or long-term notes. b. Investments in tangible fixed assets not currently used in operations. c. Investments set aside in special funds (sinking, pension, plant expansion, etc.) and the cash surrender value of life insurance. d. Investments in nonconsolidated subsidiaries or affiliated companies. Long-term investments are rather permanent in nature as they are not normally disposed of for a long period of time. They are shown in the balance sheet below current assets in a separate section called Investments. Property,Plantand Equipment 9. Property, plant and equipment are properties of a durable nature that are used in the regular operations of the enterprise. Examples include land, land improvements, buildings, machinery, furniture, tools, and wasting resources. With the exception of land, these assets are either depreciable or depletable. IntangibleAssets 10. Intangible assets lack physical substance. However, their benefit lies in the rights they convey to the holder. Examples include patents, copyrights, franchises, goodwill, trademarks, trade names, and secret processes. 11. Limitedlife intangible assets are amortized over their useful lives. Indefinitelife intangibles (such as goodwill) are not amortized but, instead, are assessed at least annually for impairment. OtherAssets 12. Many companies include an Other Assets classification in the balance sheet after Intangible Assets. This section includes a wide variety of items that do not appear to fall clearly into one of the other classifications. Some of the more common items included in this section are: deferred charges, noncurrent receivables, prepaid pension costs, deferred income taxes, and advances to subsidiaries. CurrentLiabilities 13. Current liabilities are the obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities. Items normally shown in the current liabilities section of the balance sheet include notes and accounts
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payable, advances received from customers, current maturities of long-term debt, taxes payable, and accrued liabilities. Obligations due to be paid during the next year may be excluded from the current liability section if the item is expected to be refinanced through long-term debt or the item will be paid out of noncurrent assets. 14. Working capital is the excess of current assets over current liabilities. This concept, sometimes referred to as net working capital, represents the net amount of a companys relatively liquid resources. LongTermLiabilities 15. Longterm liabilities are obligations whose settlement dates extend beyond the normal operating cycle or one year, whichever is longer. Examples include bonds payable, notes payable, lease obligations, and pension obligations. Generally, the disclosure requirements for long-term liabilities are quite substantial as a result of various covenants and restrictions included for the protection of the lenders. Long-term liabilities that mature within the current operating cycle are classified as current liabilities if their liquidation requires the use of current assets. Long-term liabilities generally fall into one of the three following categories: a. Obligations arising from specific financing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable. b. Obligations arising from the ordinary operations of the company such as pension obligations and deferred income tax liabilities. c. Obligations that depend on the occurrence or non-occurrence of one or more future events to confirm the amount payable, or the date payable, such as product warranties and other contingencies. OwnersEquity 16. The owners equity section of the balance sheet includes information related to capital stock, additional paid-in capital, and retained earnings. Preparation of the owners equity section should be approached with caution because of the various restrictions imposed by state corporation laws, liability agreements, and voluntary actions of the board of directors. BalanceSheetFormat 17. (L.O. 3)The account format of a classified balance sheet lists assets by sections on the left side and liabilities and stockholders equity by sections on the right side. The report format lists liabilities and stockholders equity directly below assets on the same page. Statementof CashFlows

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18. (L.O. 4)The primary purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. The statement of cash flows answers three questions: a. b. c. Where did the cash come from during the period? What was the cash used for during the period? What was the change in the cash balance during the period?

19. (L.O. 5)In accomplishing its purpose, the statement focuses attention on three different activities related to cash flows. a. Operatingactivities involve the cash effects of transactions that enter into determination of net income. b. Investing activities include making and collecting loans and acquiring and disposing of debt and equity investments and property, plant, and equipment. c. Financing activities involve liability and owners equity items and include (1) obtaining resources from owners and providing them with a return on their investment and (2) borrowing money from creditors and repaying the amounts borrowed. The basic format of the statement of cash flows is shown below. Statementof CashFlows Cash flows from operating activities................... Cash flows from investing activities................... Cash flows from financing activities................... Net increase (decrease) in cash......................... Cash at beginning of year.................................. Cash at end of year............................................ $XXX XXX XXX XXX XXX $XXX

20. The statement of cash flows value is that it helps users evaluate liquidity, solvency, and financial flexibility. 21. (L.O. 6)The information to prepare the statement of cash flows comes from three sources: (a) comparative balance sheets, (b) the current income statement, and (c) selected transaction data. Preparation of the statement of cash flows involves the following steps. a. Determine the cash provided by operations. b. Determine the cash provided by or used in investing and financing activities. c. Determine the change (increase or decrease) in cash during the period. d. Reconcile the change in cash with the beginning and the ending cash balances.

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The information included in this chapter on the preparation of the statement of cash flows provides a basic introduction to the concepts involved. A complete and detailed presentation of the statement of cash flows is found in Chapter 23 of the text.

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Usefulnessof the Statementof CashFlows 22. (L.O. 7)Creditors look for answers to the following questions in the companys cash flow statement: a. How successful is the company in generating net cash provided by operating activities? b. What are the trends in net cash flow provided by operating activities over time? c. What are the major reasons for the positive or negative net cash provided by operating activities? FinancialLiquidity 23. The current cash debt coverage ratio indicates whether the company can pay off its current liabilities from its operations in a given year. Net Cash Provided by Operating Activities Average Current Liabilities FinancialFlexibility 24. The cash debt coverage ratio measures a companys ability to repay its liabilities from net cash provided by operating activities. Net Cash Provided by Operating Activities Average Total Liabilities FreeCashFlow 25. Free cash flow is the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity. Net Cash Provided by Operating Activities SupplementalDisclosures 26. (S.O. 8)Supplemental disclosures related to contingencies, accounting policies, contractual situations, and fair values provide for elaboration or qualification of items listed in the balance sheet. 27. A contingencyis defined as an existing situation involving uncertainty as to a possible gain (gain contingency) or loss (loss contingency) that will ultimately be resolved when one or more future events occur or fail to occur. In short, they are uncertain occurrences that may have a material effect on financial position.
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Current Cash Debt Coverage Ratio

Cash Debt Coverage Ratio

Capital Expenditures

Dividends

= Free Cash Flow

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28. The methods used to value assets and allocate costs vary considerably among balance sheet accounts. To help users of the financial statements understand and evaluate financial statement components and their relationships, these valuation methods are normally disclosed in a separate Summary of Significant Accounting Policies preceding the financial statement notes. In addition to contingencies and valuation methods, any contractual situations of significance should be disclosed. These items include pension obligations, lease contracts, stock options, etc. Fair Values 29. Financial instruments are defined as cash, an ownership interest, or a contractual right to receive, or an obligation to deliver cash or another financial instrument. Companies are to follow a fair value hierarchy that provides insight into how to determine fair values. Level 1 (the most reliable) measures are based on observable inputs, such as market price for identical assets or liabilities. Level 2 (less reliable) measures are based on market-based inputs other than those included in Level 1, such as those based on market prices for similar assets or liabilities. Level 3 (least reliable) measures are based on unobservable inputs, such as a companys own data or assumptions. In addition, companies must provide significant additional disclosure related to Level 3 measurements. Techniquesof Disclosure 30. (S.O. 9)Effective communication of the information required to be disclosed in financial statements is an important consideration. Accountants have developed certain methods that have proven useful in disclosing pertinent information. The methods are parenthetical explanations, notes, cross reference and contra items, and supporting schedules. Numerous examples of the techniques of disclosure are presented in the text. Terminology 31. The balance sheet should contain descriptive labels that readers will generally understand and clearly interpret. The profession has recommended that companies use the work reserve only to describe an appropriation of retained earnings. In addition, the profession has recommended that the use of the work surplus be discontinued in the equity section of the balance sheet.

*RatioAnalysis *32. (S.O. 10) Appendix5A Ratio Analysis. Demonstrates various ratios used to analyze financial performance.

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LECTUREOUTLINE
It should be emphasized that this chapter is a review chapter and the intent is to provide an overview for topics that will be dealt with in greater detail in later chapters. As a review of Chapters 4 and 5, we recommend that you encourage students to examine a set of actual financial statements and the accompanying notes. Appendix 5-B in the text contains specimen financial statements for The Procter & Gamble Company. The material in the chapter can be covered in two class sessions. The first session can be used for lecture on the concepts covered in the chapter. Most students should have had previous exposure to these concepts. The first session can also be used for reviewing some of the shorter problem material such as Exercises 5-1 through 5-4 and Cases 5-1 through 5-3. You may wish to call upon students for their answers to the items in these exercises and cases. Most items are straightforward, but some of them will stimulate class discussion and highlight areas of misunderstanding. The second class session can be used for final review and for going over the longer problem material. This material allows students to apply chapter concepts by critiquing and preparing financial statements. TEACHING TIP As a comprehensive review of Chapters 4 and 5, use Illustration 5-7 to discuss the specimen financial statements of The Procter & Gamble Company that appear in Appendix 5-B in the textbook. Reproduce and distribute Illustration 5-7. The exercise can be used as either an inclass assignment or as a homework assignment. A. (L.O. 1)Usefulness of the Balance Sheet. 1. 2. 3. Provides information about entitys assets, liabilities, and equity. Aids in assessingrisk and predictingfuturecashflows. Evaluation of liquidity, solvency, and financialflexibility.

B. Limitations of the Balance Sheet. 1. 2. Fair value is not reflected. Estimates and judgments must be utilized: a. b. c. in determining the collectibility of receivables. in determining the useful lives of long-term assets. in assessing the number of inventory returns.

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3.

Omits many items that are of financial value to the business. a. Assets such as the value of a companys knowledge, skills, human resources, and research and development are not reported. Some liabilities or commitments such as leases and certain contractual arrangements are reported in an off-balance-sheet manner, or not at all.

b.

C. (L.O. 2)Classifications in the Balance Sheet. TEACHING TIP Illustration5-1 can be used in a discussion of the major classifications and subclassifications in the balance sheet. 1. 2. 3. Assets. Liabilities. Equity.

D. Major Subclassifications in the Balance Sheet. 1. Currentassets. TEACHING TIP Illustration 5-2 can be used in discussing the relationship among current assets, current liabilities, working capital and the operating cycle. a. Definition: 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. (Point out the distinction between the operatingcycle and the accountingcycle.) Point out some conceptual weaknesses in the classification of current assets: (1) Prepaid expenses will neither be turned into cash nor used to pay a current liability. Discuss the justification for including them in current assets. (2) Consumption of plant assets during the current period: conceptually, the current depreciation and amortization charges should be classified as current assets, analogous to the currently maturing portion of long-term debt. c. Items included in the current assets section are presented in the order of liquidity. (1) Cash. Any cash restricted for purposes other than current obligations is excluded from current assets.
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b.

(2) Short-term investments. Investments in debt securities are classified as either trading, availablefor-sale, or held-to-maturity, while investments in equity securities are classified as either trading or available-for-sale. Trading and available-for-sale securities are reported at fair value, while held-to-maturity securities are reported at amortized cost. Trading securities are classified as current, while available-for-sale and held-to-maturity are classified as current or noncurrent based on circumstances. (3) Receivables. The amounts of expected uncollectibles, nontrade receivables, and accounts pledged or discounted must be disclosed. (4) Inventories. The basis of valuation (e.g., cost or the lower-of-cost-or-market), pricing method (e.g., FIFO, LIFO, etc.), and stage of completion of manufactured inventories should be disclosed. (5) Prepaid expenses. Included as current assets if a company will receive benefits within one year or the operating cycle, whichever is longer. 2. Longterm investments . The management intends is to hold these investments for an extended period of time. a. b. Investments in securities: bonds, common stock, long-term notes. Investments in tangible fixed assets not currently used in operations: land held for speculation. Investments set aside in special funds: sinking funds, pension funds, plant expansion funds, and cash surrender value of life insurance. Investments in nonconsolidated subsidiaries or affiliated companies.

c.

d. 3.

Property, plant, and equipment. Tangible long-lived assets such as land, buildings, machinery, furniture, and wasting resources (timberland, minerals) used in operations. a. Most assets in this category are either depreciable (e.g., buildings) or consumable (e.g., timberlands). Land is not depreciated. However, land improvements are depreciated. The basis of valuation (e.g., historical cost), any liens against the property, and accumulated depreciation or depletion must be disclosed. In practice, a detailed classification of property, plant, and equipment is disclosed in a supplementary schedule rather than on the face of the balance sheet.

b.

c.

4.

Intangible assets . Assets that lack physical substance, which are not financial instruments, but represent significant economic resources.

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a.

Examples include patents, franchises, copyrights, goodwill, trademarks, trade names, and customer lists. Limitedlife intangible assets are amortized over their useful lives and reported net of the accumulated amortization. Indefinitelife intangibleassets, such as goodwill, are not amortized but are assessed periodically for impairment.

b. c. 5.

Other assets. A special classification for unusual items that cannot be included in one of the other asset categories. a. b. Examples include long-term prepaid expenses, noncurrent receivables, and deferred income taxes. This section should include only unusual items sufficiently different from assets included in specific categories.

6.

Point out that the classification of assets depends on both the nature of the item and the use to which it is put. For example: a. b. Land used as factory siteclassify as property, plant, and equipment. Land held for speculationclassify as long-term investment.

7.

Currentliabilities. a. b. Definition: Obligations that are reasonably expected to be liquidated through the use of current assets or the creation of other current liabilities. Examples: (1) Payables resulting from the acquisition of goods and services: accounts payable, wages payable, taxes payable. (2) Collections received in advance for the delivery of goods or performance of services: unearned rent revenue, unearned subscriptions revenue. (3) Other liabilities whose liquidation will take place within the operating cycle: long-term bonds to be paid in the current period, short-term obligations arising from purchase of equipment. c. d. Companies most commonly list notes payable, accounts payable, or short-term debt as the first item. Some liabilities that will be paid within a year are reportedas longterm liabilities. This occurs when the company expects to (1) refinance the debt through another long-term issue. (2) retire the debt out of noncurrent assets.

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e.

Working capital represents the net amount of a companys relatively liquid resources. (1) Working capital = total current assets total current liabilities

8.

Longtermliabilities. a. Definition: Obligations that are not reasonably expected to be liquidated within the normal operating cycle. Companies classify long-term liabilities that mature within the current operating cycle as current liabilities if payment of the obligation requires the use of current assets. Three types: (1) Obligations arising from specific financing situations: issuance of bonds, longterm lease obligations, and long-term notes payable. (2) Obligations arising from 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 (e.g., product warranties, or other contingencies.) d. Any premium or discount on bonds is disclosed separately as an addition to or subtraction from the bonds payable. Supplementary information that is usually disclosed in separate schedules or notes to financial statements includes the existence of debt covenants and restrictions and the terms of the debt, such as maturity dates, interest rates, and amounts of any securities pledged to support the debt.

b.

c.

e.

9.

Ownersequity. a. Stockholders equity of corporations. (1) Capital stock.The par or stated value of the shares issued. (a) The number of authorized, issued, and outstanding shares and the par value amounts must be disclosed. (b) Treasury stock is shown as a reduction of stockholders equity. (2) Additional paid-in capital. The excess of amounts paid, in over the par or stated or par value.

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(3) Retained earnings. The undistributed earnings of the corporation. Separate disclosure is made of unappropriated (available for dividends) and appropriated (restricted) retained earnings. TEACHING TIP Use the illustrations on text pages 226 and 227 to discuss stockholders equity sections. E. (L. O. 3) Balance Sheet Format. 1. Report and account formats. a. Account form: lists assets on the left side and liabilities and stockholders equity on the right side. Report form: lists assets first, followed by liabilities and stockholders equity immediately below.

b.

F. Statement of Cash Flows. TEACHING TIP Use Illustrations5-3 and 5-4 to give an overview of the statement of cash flows. 1. (L.O. 4)Purpose of the statement. a. The primary purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of a company during a period. It reports the operating, investing, and financing transactions of the business.

b. 2.

The statement is useful because it provides answers to the following important questions: a. b. c. Where did the cash come from during the period? What was the cash used for during the period? What was the change in the cash balance during the period?

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3.

(L.O. 5) Content of the statement of cash flows. a. Operating activities. Involve the cash effects of transactions that enter in the determination of net income. Investing activities.Involve making and collecting loans, and acquiring and disposing of debt and equity investments and property, plant, and equipment. Financing activities. Include obtaining capital from owners and providing them a return on their investment, and borrowing money from creditors and repaying the amounts borrowed.

b.

c.

4.

Preparing a basic statement of cash flows. a. Determine the cash provided by operations. b. Determine the cash provided by or used in investing and financing activities. c. Determine the change (increase or decrease) in cash during the period. d. Reconcile the change in cash with the beginning and the ending cash balances.

5.

Investing activities and financing activities. InvestingActivities Cash from selling property, plant & equipment Cash from the sale of debt/equity investments Collection of loans Purchase of property, plant, & equipment Purchase of debt/equity investments Loans to other entities FinancingActivities Issuance of equity securities Issuance of debt Payment of dividends Redemption of debt Reacquisition of capital stock

6.

Significant noncash activities. a. All significant noncash financing and investing activities are reported in either a separate schedule at the bottom of the statement or in separate notes to the financial statements. Examples of transactions that must be disclosed: (1) Issuance of common stock to purchase assets. (2) conversion of bonds to common stock. (3) Issuance of debt to purchase assets. (4) Exchanges of long-lived assets.

b.

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G. (L.O. 7)Usefulness of the statement of cash flows. 1. 2. Information on the statement is used to evaluate liquidity, solvency, and financial flexibility. Analysis of net cash provided by operating activities includes: a. b. c. Current cash debt coverage. Used to determine whether a company can pay off its current liabilities from its operating activities. It evaluates financial liquidity. Cash debt coverage. Used to determine whether a company can repay its liabilities from its operating activities. It evaluates financial flexibility. Free cash flow. Used to determine the discretionary cash flow a company has to purchase additional investments, retire its debt, purchase treasury stock, or add to its liquidity. TEACHING TIP Illustration5-5 provides the formulas for analyzing net cash provided by operating activities. H. (L.O. 8)Supplemental disclosures. 1. Contingencies Material events that have an uncertain outcome. a. Gain contingencies may be related to tax operating loss carryforwards or company litigation against another party. Loss contingencies may relate to litigation, environmental issues, possible tax assessments, or government investigations.

b.

2.

Accountingpolicies. a. GAAP recommends disclosure for all significant accounting principles and methods that involve selection from among alternatives or those that are peculiar to a given industry. This disclosure is usually given in a separate Summary of Significant Accounting Policies preceding the notes to the financial statements or as the initial note. Companies must also disclose information about the nature of their operations, the use of estimates in preparing financial statements, and vulnerabilities due to certain concentrations.

b.

c.

3.

Contractual situations. Companies should disclose the essential provisions of lease contracts, pension obligations, and stock option plans in the notes to the financial statements. Fair values.
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4.
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a.

Financial Instruments are defined as cash, an ownership interest, or a contractual right to receive or obligation to deliver cash or another financial instrument. Can be either assets or liabilities. Both the carrying value and the estimated fair value of financial instruments must be disclosed in the financial statements.

b. c.

I. (L.O. 9)Techniques of Disclosure. 1. 2. 3. 4. 5. Parentheticalexplanations(Example: net of tax calculations in Chapter 4). Notes(Example: accounting policies and contingencies). Crossreferenceand contraitems(Example: bond discounts). Supportingschedules(Example: lease disclosures). Terminology. a. The term reserve should be used only to describe an appropriation of retained earnings. Use of the term surplus is discouraged.

b.

*J. (L.O. 10)APPENDIX5-A.Ratio Analysis. 1. 2. Used to express the relationships between selected financial statement data. Can be classified as: a. Liquidity ratios.Measures the companys short-term ability to pay its maturing obligations. Activityratios.Measures how effective a company uses its assets. Profitabilityratios.Measures the success or failure of a company. Coverage ratios.Measures the degree of protection for long-term creditors and investors. TEACHING TIP Use Illustration5-6 to discuss the specific ratios included in each classification. *K. APPENDIX5-B.Specimen financial statements.
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b. c. d.

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TEACHING TIP Use the questions in Illustrations5-7 and 5-8 to review the financial statements of The Procter & Gamble Company. *L. (L.O. 11) IFRSInsights 1. As in GAAP, the balance sheet and the statement of cash flows are required statements for IFRS. In addition, the content and presentation of an IFRS balance sheet and cash flow statement are similar to those used for GAAP. In general, the disclosure requirements related to the balance sheet and the statement of cash flows are much more extensive and detailed in the United States. IAS 1, Presentation of Financial Statements, provides the overall IFRS requirements for balance sheet information. IAS 7, Cash Flow Statements, provides the overall IFRS requirements for cash flow information. IFRS insights on the statement of cash flows are presented in Chapter 23. RelevantFacts a. Similarities (1) Both IFRS and GAAP allow the use of title balance sheet or statement of financial position. IFRS recommends but does not require the use of the title statement of financial position rather than balance sheet. (2) Both IFRS and GAAP require disclosures about (1) accounting policies followed, (2) judgments that management has made in the process of applying the entitys accounting policies, and (3) the key assumptions and estimation uncertainty that could result in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. Comparative prior period information must be presented and financial statements must be prepared annually. (3) IFRS and GAAP require presentation of noncontrolling interests in the equity section of the balance sheet. b. Differences (1) IFRS requires a classified statement of financial position except in very limited situations. IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities. However under GAAP, public companies must follow SEC regulations, which require specific line items. In addition, specific GAAP mandates certain forms of reporting this information.

2.

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(2) Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last. (3) IFRS has many differences in terminology that you will notice in this textbook. (4) Use of the term reserve is discouraged in GAAP, but there is no such prohibition in IFRS.

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5-23

ILLUSTRATION5-1 BALANCESHEETCLASSIFICATIONS

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ILLUSTRATION5-2 CURRENTASSETCLASSIFICATION

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ILLUSTRATION5-3 STATEMENTOF CASHFLOWS

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ILLUSTRATION5-4 STATEMENTOF CASHFLOWS(INDIRECTMETHOD)

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ILLUSTRATION5-5 FORMULASFORANALYZINGNETCASHPROVIDED BY OPERATINGACTIVITIES

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ILLUSTRATION5-6 RATIOS

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ILLUSTRATION5-7 QUESTIONSCOVERINGTHEFINANCIALSTATEMENTS OF THEPROCTER& GAMBLECOMPANY

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ILLUSTRATION5-7 (continued)

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ILLUSTRATION5-8 ANSWERSTO QUESTIONSABOUTTHEFINANCIAL STATEMENTSOF THEPROCTER& GAMBLECOMPANY

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ILLUSTRATION5-8 (continued)

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ILLUSTRATION5-8 (continued)

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