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Spiceland 9e IM CH 3 Chapter Overview

Intermediate I (Northwestern State University of Louisiana)

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CHAPTER 3
THE BALANCE SHEET AND FINANCIAL DISCLOSURES

Overview
Chapter 1 stressed the importance of the financial statements in helping investors and creditors
predict future cash flows. The balance sheet, along with accompanying disclosures, provides
relevant information useful in helping investors and creditors not only to predict future cash flows,
but also to make the related assessments of liquidity and long-term solvency.
The purpose of this chapter is to provide an overview of the balance sheet and financial
disclosures and to explore how this information is used by decision makers.

Learning Objectives
LO3–1 Describe the purpose of the balance sheet and understand its usefulness and limitations.
LO3–2 Identify and describe the various balance sheet asset classifications.
LO3–3 Identify and describe the various liability and shareholders' equity classifications.
LO3–4 Explain the purpose of financial statement disclosures.
LO3–5 Describe disclosures related to management's discussion and analysis, responsibilities, and
compensation.
LO3–6 Explain the purpose of an audit and describe the content of the audit report.
LO3–7 Describe the techniques used by financial analysts to transform financial information into
forms more useful for analysis.
LO3–8 Identify and calculate the common liquidity and solvency ratios used to assess risk.
LO3–9 Discuss the primary differences between U.S. GAAP and IFRS with respect to the balance
sheet, financial disclosures, and segment reporting.

Part A: The Balance Sheet

I. Usefulness
A. The balance sheet, sometimes referred to as the statement of financial position, provides
information useful for assessing future cash flows, liquidity, and long-term solvency.
II. Limitations
A. Assets minus liabilities, measured according to GAAP, is not likely to be representative of
the market value of the entity (number of common stock shares outstanding multiplied by
price per share).

III. Classification of Elements

A. Assets are probable future economic benefits obtained or controlled by a particular entity
as a result of past transactions or events. Simply, these are the economic resources of a
company.
1. Current assets include cash and all other assets expected to become cash or be
consumed within one year or the operating cycle, whichever is longer.
a. Cash and cash equivalents
b. Short-term investments
c. Accounts receivable
d. Inventories
e. Prepaid expenses
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2. Long-term (or noncurrent) assets are those assets that are expected to provide benefits
beyond the next year (or operating cycle).
a. Investments
b. Property, plant, and equipment
c. Intangible assets
d. Other long-term assets
B. Liabilities are 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. Simply, these are the obligations of a
company.
1. Current liabilities, in general, are expected to be satisfied within one year or the
operating cycle, whichever is longer.
a. Accounts payable
b. Notes payable
c. Deferred revenues
d. Accrued liabilities
e. Current maturities of long-term debt
2. Long-term liabilities are obligations that will not be satisfied in the next year or
operating cycle, whichever is longer.
C. Shareholders' equity is the residual interest in the assets of an entity that remains after
deducting liabilities. Stated another way, stockholders’ equity equals total assets minus
total liabilities. The two primary components of equity include paid-in capital and retained
earnings.
1. Paid-in capital represents the amounts invested by shareholders.
2. Retained earnings represents the accumulated net income reported since the inception
of the company and not yet paid to shareholders.
Shareholders’ equity also includes:
3. Accumulated other comprehensive income (loss). This represents changes in equity
(other than transactions with owners, such as issuing shares and paying dividends) not
reported in net income.
4. Treasury stock. This represents a company's purchase (but not retirement) of its own
stock.
D. There are more similarities than differences in balance sheets prepared according to U.S.
GAAP and those prepared applying IFRS.

Part B: Financial Disclosures

I. Disclosure Notes
A. Disclosure notes include certain required notes as well as notes fashioned to suit the
disclosure needs of the reporting enterprise.
B. The summary of significant accounting policies conveys valuable information about the
company's choices from among various alternative accounting methods.
C. A subsequent event is a significant development that takes place after the company's fiscal
year-end but before the financial statements are issued.
D. Related-party transactions are those between the company and owners, management,
families of owners or management, affiliated companies, and other parties that can
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significantly influence or be influenced by the company. The economic substance of

related-party transactions should be disclosed, including dollar amounts involved.

II. Management’s Discussion and Analysis

The management’s discussion and analysis provides a biased but informed perspective of a
company's (a) operations, (b) liquidity, and (c) capital resources.

III. Management's Responsibilities

Annual reports include a management's responsibility section that asserts the responsibility of
management for the information contained in the annual report as well as an assessment of the
company's internal control procedures.

IV. Compensation of Directors and Top Executives

A. The proxy statement, which must be provided each year to all shareholders, serves as an
invitation to attend the company's annual meeting and as a means to vote on issues before
the shareholders.
B. The proxy statement also contains disclosures on compensation to directors and
executives.

V. Auditors' Report
A. The auditors' report provides an independent and professional opinion about the fairness
of the representations in the financial statements and about the effectiveness of the
company’s internal control over financial reporting.
B. The four basic types of auditors' reports are:
1. Unqualified (or “clean”)
2. Unqualified with an explanatory paragraph (lack of consistency, going concern, or
emphasis of matter)
3. Qualified (scope limitation or departure from GAAP)
4. Adverse (serious misstatement) or disclaimer (severe scope limitation)

Part C: Risk Analysis

I. Using Financial Statement Information
A. Financial analysts use various techniques when analyzing financial statement information.
1. Comparative financial statements—compare year-to-year financial position, results of
operations, and cash flows.
2. Horizontal analysis—percentage change in financial statement item since a base year.
3. Vertical analysis—financial statement item expressed as a percentage of a total
amount.
4. Ratio analysis—convert financial statement items to ratios.
B. The most common way of comparing accounting numbers to evaluate the performance
and risk of a firm is ratio analysis.

II. Liquidity Ratios

A. Liquidity refers to the ability of a company to convert its assets to cash to pay its current
obligations.

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B. Working capital, the difference between current assets and current liabilities, is a popular
measure of a company's ability to satisfy its short-term obligations.
C. The current ratio, calculated by dividing current assets by current liabilities, expresses
working capital as a ratio that allows for interfirm comparisons.
D. The acid-test ratio provides a more stringent indication of a company's ability to pay its
current obligations. The ratio excludes inventories and prepaid expenses from current
assets before dividing by current liabilities.

III. Solvency Ratios

A. Solvency ratios provide some indication of the riskiness of a company with regard to its
ability to pay its long-term debts.
B. The debt to equity ratio indicates the extent of reliance on creditors, rather than owners, in
providing resources.
1. The ratio is calculated by dividing total liabilities by total shareholders' equity.
2. The debt to equity ratio indicates the extent of trading on the equity or financial
leverage.
C. The times interest earned ratio indicates the margin of safety provided to creditors. It is
calculated by dividing income before subtracting either interest expense or taxes by
interest expense.
D. Favorable financial leverage means earning a return on borrowed funds that exceeds the
cost of borrowing the funds.

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