Balance Sheet - FSA

The Balance Sheet
• 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 firms owns
and what the firm owes to
outsiders and to internal owners
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Financial Condition
Assets  Liabilitie s  Stockholde rs' 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.

Financial Condition
Consolidation
• Parent company owns more
than 50% of voting stock.
• Financial statements are
combined.

Financial Condition
Balance Sheet Date

• The date the balance sheet is
prepared
• Could be the end of the
calendar year, fiscal year,
quarter, etc.

Financial Condition
Comparative Data
• SEC requires two-year audited
balance sheets.
• Provides a reference point for
determining changes in
financial position

Financial Condition
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

Financial Condition

Assets
Segregated according to how they

are utilized
• Current Assets
• Property, Plant, and
Equipment
• Other Assets
Assets
Current Assets
• Expected to be converted to
cash within one year or one
operating cycle
• Continually used up and
replenished

Assets
Current Assets
• Operating cycle
 Time required to purchase or
manufacture inventory, sell the
product, and collect the cash
• Working capital
 Also called net working capital
 Current assets less current liabilities

Assets
Current Assets
• Cash and cash equivalents
• Marketable securities
• Accounts receivable
• Inventories
• Prepaid expenses

Assets

Assets
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

Assets
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

Assets
Current Assets – Accounts

Receivable
• Customer balances outstanding
on credit sales
• Net realizable value – actual
amount of account less an
allowance for doubtful accounts
Assets

Receivable
• 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

Assets
The allowance account for Sage Inc.

represents approximately 5% of
accounts receivable:

Assets

Receivable
• There should be a consistent
relationship between the rate
of change in sales, accounts
receivable, and the allowance
for doubtful accounts.

Assets
Sage Inc.

Assets
To analyze the preceding information, consider

the following:
• Are all three accounts changing in the same
directions and at consistent rates of change?
• If the direction and rates of change are not
consistent, what are possible explanations for
these differences?
• If there is not a normal relationship between
the growth rates, what are possible reasons
for the abnormal pattern?

Assets
For Sage Inc.,

• Sales, accounts receivable, and the allowance
for doubtful accounts have all increased.
• Allowance account has increased
appropriately in relation to accounts
receivable.
• Sales have grown at a much greater rate.
 More sales in cash have probably been
collected.
 Sage will probably experience fewer defaults.

Assets
Current Assets – Accounts Receivable

• Additional information helpful to the
analysis of accounts receivable and
the allowance account is provided in
the schedule of “Valuation and
Qualifying Accounts.”
 Additions Charged to Costs and
Expenses
 Deductions

Assets

Assets
• “Additions Charged to Costs and Expenses” is the

amount estimated and recorded as bad debt
expense each year on the income statement.
• “Deductions” is the actual amount the firm has
written off as accounts receivable they no longer
expect to recover.
• Analyst should use this schedule to assess the
probability that the firm is intentionally over- or
underestimating the allowance account.
• Sage Inc. appears to estimate an expense fairly
close to the actual amount written of each year.

Assets
Current Assets – Inventories

• Items held for sale
• Items used in the manufacture
of products that will be sold
• Major revenue producer for
most companies

Assets

• Retail companies
 Finished goods
• Manufacturing companies
 Raw materials
 Work-in-process
 Finished goods
• Service –oriented companies

 Little to no inventory

Assets

Assets

• Inventory Accounting Methods
 Method used has considerable impact on financial
position and operating results.
 Valuation is based on an assumption regarding the
flow of goods, not the actual order in which
products are sold.
 Cost flow assumption is made in order to match
the cost of products sold to the revenue generated.
 Disclosure of inventory cost flow assumption is
found in the notes.

Assets

 First in, first out (FIFO)
 Last in, first out (LIFO)
 Average cost

Assets

Assets
Example – A new company in its first

year of operations purchases five products
for sale in the order and at the prices
shown. The company sells three of these
items at the end of the year.
Item Purchase Price
#1 $5
#2 $7
#3 $8
#4 $9
#5 $11

Assets
Cost flow assumptions
Resulting effect on the income statement and

balance sheet

Assets

 During a period of inflation, the LIFO
method typically produces
• the highest cost of goods sold expense
• the lowest ending valuation of inventory
• undervalued inventories on the balance
sheet
• cost of goods sold values at current cost of
inventory items

Assets

 During a period of inflation, the FIFO
• the lowest cost of goods sold expense
• the highest ending valuation of inventory
• inventory values on the balance sheet that
are at current cost
• cost of goods sold values below the current
cost of inventory items

Assets

 During a period of deflation, the FIFO
• the highest cost of goods sold expense
• the lowest ending valuation of inventory
• undervalued inventories on the balance
sheet
• cost of goods sold values at current cost of
inventory items

Assets

 During a period of deflation, the LIFO
• the lowest cost of goods sold expense
• the highest ending valuation of inventory
• inventory values on the balance sheet that
are at current cost
• cost of goods sold values below the current
cost of inventory items

Assets
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

Assets
Property, Plant, and Equipment (PP&E)

• 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

Assets
Property, Plant, and Equipment (PP&E)

• The relative proportion of fixed assets in a
company’s asset structure will largely be
determined by the nature of the business.
• Manufacturing firms typically have higher
percentages of fixed assets than retailers or
wholesalers.
• Firms with newly purchased assets will have
higher percentages of fixed assets than firms
with older fixed assets.

Assets

Assets
Property, Plant, and Equipment

• Land
• Buildings
• Leasehold improvements
• Construction in progress
• Equipment

Assets
PP&E – Land
• Property used in business
• Not investment property

Assets
PP&E – Buildings
• Buildings owned by the
company
 Stores
 Corporate offices

Assets
PP&E – Leasehold Investments

• Additions made to leased structures
• Improvements made to leased
structures
• Revert to the property owner when the
lease expires
• Amortized by the lessee over the
economic life of the improvement (or
the life of the lease)

Assets
PP&E – Construction in Progress

• Costs of constructing new
buildings that are not yet
complete

Assets
PP&E – Equipment
• Original cost of machinery and
equipment used in business
operations

Assets
PP&E – 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.

Assets
PP&E – Depreciation Methods

• Straight-line method allocated an
equal amount of expense to each
year of the depreciation period.
• Accelerated methods apportions
larger amounts of expense to earlier
years of the asset’s depreciable life.
• Units-of-production method bases
depreciation expense on actual use.

Assets
Example – Assume that Sage Inc.

purchases an artificial ski mountain
for its Phoenix flagship store in
order to demonstrate skis and allow
prospective customers to test-run
skis on a simulated course. The
cost of the mountain is $50,000
and is expected to have a five-year
useful life and $0 salvage value at
the end of that period.

Assets

Assets

Assets
Goodwill
• Arises when one company acquires another
company for a price in excess of the fair
market value of the net identifiable assets
acquired
• Evaluated annually
 If no loss of value has occurred, goodwill
remains on the balance sheet.
 If the book value exceeds the fair value, the
excess must be written off as an impairment
expense

Assets
Other Assets
• Can include a multitude of other noncurrent
items
 Property held for sale
 Start-up costs associated with a new business
 Cash surrender value of life insurance
policies
 Long-term advance payments
 Intangible assets (other than goodwill)

Liabilities
• Represent claims against assets

• Current liabilities
 Must be satisfied in one year or
one operating cycle
• Noncurrent liabilities
 Obligations with maturities beyond
one year

Liabilities

Liabilities
Current Liabilities
• Accounts payable
• Notes payable
• Current portion of long-term
debt
• Accrued liabilities
• Unearned revenue
Liabilities
Current Liabilities – Accounts Payable

• Short-term obligations that arise
from credit extended by suppliers for
the purchase of goods and services
• Eliminated when the bill is satisfied
• Increase and decrease depending on
credit policies, economic conditions,
and cyclical nature of operations

Liabilities
Current Liabilities – Notes Payable

• Also referred to as short-term
debt
• Short-term obligations in the
form of promissory notes
• Lines of credit to suppliers or
financial institutions

Liabilities
Current Liabilities – Current

Maturities of Long-term Debt
• Portion of the principal of
long-term debt that will be
repaid during the upcoming
year

Liabilities
Current Liabilities – Accrued Liabilities

• Result from recognition of an expense prior
to actual payment of cash
• Reserve accounts
 Set up for the purpose of estimating
obligations for items such as warranty costs,
sales returns, or restructuring charges
 Identified in the notes to the financial
statements

Liabilities
Current Liabilities – Accrued Liabilities

Example – Assume that a company has a $100,000
note outstanding with 12% interest due in semiannual
installments on March 31 and September 30. For a
balance sheet prepared on December 31, interest will
be accrued for three months (October, November,
and December). The December 31 balance sheet
would include an accrued liability of $3,000:
$10,000 x 0.12 = $12,000 annual interest

$12,000/12 = $1,000 monthly interest
$1,000 x 3 = $3,000 accrued interest for three months

Liabilities
Current Liabilities – Unearned Revenue

• Also called deferred credits
• Result from payments received in
advance for services and products
• Transferred to a revenue account
when the service is performed or the
product is delivered

Liabilities
Deferred Taxes
• Result of temporary differences
in the recognition of revenue and
expense for taxable income
relative to reported income
• Depreciation methods are the
most common source for
temporary differences.

Liabilities
Deferred Taxes
• Other temporary differences arise from
methods used to account for
 Installment sales
 Long-term contracts and leases
 Warranties and service contracts
 Pensions and other employee benefits
 Subsidiary investment earnings

Liabilities
Deferred Taxes
• Permanent differences in
income tax accounting do not
affect deferred taxes.
 Municipal bond revenue
 Life insurance premiums

Liabilities
Deferred Taxes
• Valuation allowance
 Used to reduce deferred tax assets
to expected realizable amounts
 Used when it is more likely than
not that some of the deferred tax
assets will not be realized

Liabilities
Example – Assume that a company has a total

annual revenue of $500,000, expenses other
than depreciation of $250,000, and a
depreciation expense of $100,000 for tax
accounting and $50,000 for financial reporting.
The income for tax reporting purposes would be
computed two ways, assuming a 34% tax rate:

Liabilities
Taxes actually paid ($51,000) are less than

the tax expense ($68,000) reported in the
financial statements. To reconcile the
$17,000 difference between the expense
recorded and the cash outflow, there is a
deferred tax liability of $17,000:

Liabilities

Liabilities
Deferred Taxes
• Deferred taxes are not always
classified as current liabilities.
• They may also appear on the balance
sheet as a
 current asset
 noncurrent asset
 noncurrent liability

Liabilities
Noncurrent Liabilities
• Long-term debt
• Capital lease obligations
• Postretirement benefits other
than pensions
• Commitments and contingencies
• Hybrid securities
Liabilities
Noncurrent Liabilities – Long-term Debt

• Bonds
• Long-term notes payable
• Mortgages
• Obligations under leases
• Pension liabilities
• Long-term warranties

Liabilities
Noncurrent Liabilities – Capital Lease

Obligations
• Are, in substance, a “purchase” rather
than a “lease”
• Affect both balance sheet and income
statement
• Disclosures found in the notes, often
under both the PP&E note and the
commitments and contingencies note

Liabilities
Noncurrent Liabilities – Pensions and

Postretirement Benefits
• Pensions are cash compensation paid to
retired employees.
• Postretirement benefits are benefits
other than pensions that employers
promise to pay for retired employees.
• Can appear under the liability section of
the balance sheet

Liabilities
Noncurrent Liabilities – Commitments and

Contingencies
• Commitments refer to contractual
agreements that will have a significant
financial impact in the future.
• Contingencies refer to potential liabilities
(such as possible damage awards assessed in
lawsuits).
• Intended to draw attention to the fact that
required disclosures can be found in the
notes to the financial statements.

Liabilities
Noncurrent Liabilities – Hybrid

Securities
• Have the characteristics of both debt
and equity
• Also called mandatorily redeemable
preferred stock
• Financial instrument is preferred
stock, but the issuing company must
retire the shares at a future date.

Stockholders’ Equity
• Also called shareholders’

equity
• Residual interest in assets that
remains after deducting
liabilities
• Owners bear greatest risk and
benefit from greatest rewards.

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

Common Stock
• Dividends are declared at the
discretion of a company’s board of
directors
• Amount listed on the balance sheet is
based on the par or stated value of the
shares issued (which bears no
relationship to actual market price).

Additional Paid-In Capital

• Reflects the amount by which
the original sales price of the
stock shares exceeded par
value

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 stock
• Measurement of all undistributed
earnings

Retained Earnings
• Key link between the income
statement and the balance sheet
• Unless there are unusual
transactions affecting the retained
earnings account,
Beginning Net Ending
retained ± income – Dividends = retained
earnings (loss) earnings

Other Equity Accounts

• Preferred stock
• Accumulated other comprehensive
income (expense)
• Treasury Stock
• Employee benefit trusts
• Equity attributable to noncontrolling
interests


Other Equity Accounts –

Preferred Stock
• Carries a fixed annual dividend
payment
• Carries no voting rights

Other Equity Accounts – Accumulated Other

Comprehensive Income (Expense)
• Unrealized gains or losses in the market value of
investments in available-for-sale securities
• Any change in the excess of additional pension
liability over unrecognized prior service cost
• Certain gains and losses on derivative financial
instruments
• Foreign currency translation adjustments
resulting from converting financial statements
from a foreign currency into U.S. dollars

Other Equity Accounts – Treasury Stock

• Repurchased shares of stock that are
not retired
• Shown as an offsetting account

Other Equity Accounts – Equity

Attributable to Noncontrolling
Interests
• Represents the equity interest a firm
has in companies whose financial
statement have been consolidated
with the firm’s statements but that are
not 100% owned by the firm

Quality of Financial
Reporting
• Economic recession of 2008 and many

market gyrations since can be traced directly
to overvaluation of balance sheet assets.
• When financial reporting does not reflect
economic reality quality and usefulness are
significantly impaired.
• Type of debt used to finance assets,
commitments and contingencies, and the
classification of leases relate directly to
quality of financial reporting.

Quality of Financial
Reporting
• “Commitments and Contingencies”

disclosure in the notes to financial
statements provide important
information about off-balance sheet
financing and other complex
financing arrangements.
• Enron is a prime example of a
company with enormous activity
reported in the “Commitments and
Contingencies” disclosure.

Other Balance Sheet Items
• Corporate balance sheets are

not limited to the accounts
described in this chapter.
• The reader of annual reports
will encounter additional
accounts and will find many of
the same accounts listed under
different titles.

Balance Sheet - FSA

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Balance Sheet - FSA

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The Balance Sheet

• Also called the statement of

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall 2-1

Assets  Liabilitie s  Stockholde rs' equity

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Balance Sheet Date

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Common-Size Balance Sheet

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Segregated according to how they

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Current Assets – Cash and Cash

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Current Assets – Marketable

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Current Assets – Accounts

Current Assets – Accounts

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The allowance account for Sage Inc.

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Current Assets – Accounts

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To analyze the preceding information, consider

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For Sage Inc.,

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Current Assets – Accounts Receivable

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• “Additions Charged to Costs and Expenses” is the

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Current Assets – Inventories

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Current Assets – Inventories

• Service –oriented companies

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Current Assets – Inventories

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Current Assets – Inventories

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Example – A new company in its first

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Cost flow assumptions

Resulting effect on the income statement and

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Current Assets – Inventories

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Current Assets – Inventories

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Current Assets – Inventories

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Current Assets – Inventories

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Current Assets – Prepaid Expenses

• Included in current assets if they expire within