Understanding Financial Statements

Twelfth Edition

Chapter 2

The Balance Sheet

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The Balance Sheet
Overview
• Also called the statement of condition or the statement of
financial position
• Shows the financial condition of a company on a
particular date
• Summarizes what the firm owns and what the firm owes
to outsiders and to internal owners

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Financial Condition (1 of 8)
Assets = Liabilities + Stockholders’ equity
• Assets are what the firm owns.
• Liabilities are what the firm owes to outsiders.
• Stockholders’ equity is what the firm owes to internal
owners.

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Financial Condition (6 of 8)
Common-Size Balance Sheet
• Expresses each item on the balance sheet as a
percentage of total assets
• Reveals the composition of assets
• Form of vertical ratio analysis
• Useful for evaluating trends within a firm
• Allows for making industry comparisons

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Assets (1 of 39)
Segregated according to how they are utilized:
• Current Assets
• Property, Plant, and Equipment
• Other Assets

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Assets (2 of 39)
Current Assets
• Continually used up and replenished
• Expected to be converted to cash within one year or one
operating cycle

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Assets (4 of 39)
Current Assets (continued)
• Cash and cash equivalents
• Marketable securities
• Accounts receivable
• Inventories
• Prepaid expenses

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Assets (6 of 39)
Current Assets – Cash and Cash Equivalents
• Cash awaiting deposit
• Cash in a bank account
• Short-term investments that can be converted to cash
within three months

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Assets (7 of 39)
Current Assets – Marketable Securities
• Short-term investments that can be converted to cash
within a year
• Three categories
– Held to maturity
– Trading securities
– Securities available for sale

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Assets (8 of 39)
Current Assets – Accounts Receivable
• Customer balances outstanding on credit sales
• Net realizable value – actual amount of account less an
allowance for doubtful accounts
• Allowance for doubtful accounts
– Affects balance sheet valuation
– Important in assessing earnings quality
– Should reflect volume of credit sales, past experiences
with customers, customer base, credit policies, collections
practices, and economic conditions

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Assets (16 of 39)
Current Assets – Inventories

• Items held for sale

• Items used in the manufacture of products to be sold

• Major revenue producer for most companies

• Retail companies
– Finished goods

• Manufacturing companies
– Raw materials
– Work-in-process
– Finished goods

• Service–oriented companies
– Little to no inventory

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Assets (19 of 39)
Current Assets – Inventories (continued)
• Inventory Accounting Methods
– First in, first out (FIFO)
– Last in, first out (LIFO)
– Average cost

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Assets (25 of 39)
Current Assets – Prepaid Expenses
• Expenses paid in advance
– Insurance
– Rent
– Property taxes
– Utilities
• Included in current assets if they expire within one year
or one operating cycle
• Generally not material to the balance sheet

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Assets (26 of 39)
Property, Plant, and Equipment
• Encompasses a company’s fixed assets
• Not used up during annual operations
• Produce economic benefits for more than one year
• Have physical substance
• Shown at book value on the balance sheet

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Assets (28 of 39)
Property, Plant, and Equipment – Depreciation
• Fixed assets (with the exception of land) are depreciated
over the period of time they benefit the firm.
• Method of allocating the cost of long-lived assets
• Original cost less estimated residual value is spread over
the asset’s expected life.

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Assets (29 of 39)
Property, Plant, and Equipment – Depreciation Methods
• Straight-line method allocates an equal amount of
expense to each year of the depreciation period.
• Accelerated methods apportion larger amounts of
expense to earlier years of the asset’s depreciable life.
• Units-of-production method bases depreciation expense
on actual use.

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Liabilities (1 of 26)
Overview
• Represent claims against assets
• Current liabilities
– Must be satisfied in one year or one operating cycle
• Noncurrent liabilities
– Obligations with maturities beyond one year

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Liabilities (2 of 26)
Current Liabilities
• Accounts payable
• Notes payable
• Current portion of long-term debt
• Accrued liabilities
• Unearned revenue
• Deferred taxes

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Liabilities (17 of 26)
Long-term Debt
• Long-term notes payable
• Mortgage
• Debentures
• Bonds payable
• Convertible debt
• Long-term warranties

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Stockholders’ Equity (1 of 10)
Overview
• Also called shareholders’ equity
• Residual interest in assets that remains after deducting
liabilities
• Owners bear greatest risk and greatest benefit

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Stockholders’ Equity (2 of 10)
Common Stock
• Shareholders
– do not ordinarily receive a fixed return
– have voting privileges in proportion to ownership
interest
– can benefit through price appreciation
– can suffer through price depreciation
• Dividends declared at the discretion of the board
• Amount listed on the balance sheet based on the par or
stated value of the shares issued
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Stockholders’ Equity (4 of 10)
Retained Earnings
• Sum of every dollar a company has earned since inception
less any payments made to shareholders
• Funds a company has elected to reinvest in the operations of
the business rather than pay out in dividends
• Measurement of all undistributed earnings
• Key link between the income statement and the balance sheet
• Unless there are unusual transactions affecting the retained
earnings account is modeled by
Beginning retained earnings  Net income (loss ) − Dividends = Ending retained earnings

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Stockholders’ Equity (5 of 10)
Other Equity Accounts
• Preferred stock
• Accumulated other comprehensive income (expense)
• Treasury stock
• Equity attributable to noncontrolling interests

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