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Chapter 1: Introduction to Balance Sheets 1

Chapter 1
Introduction to Balance Sheets
TABLE OF CONTENTS
Introduction 4
What Do You See? 5
Exercise 1.01 12
What’s Behind the Numbers? 13
Framing Record Keeping and Reporting 13
Accounts 13
Connecting Reported Numbers to Entries 14
Bischoff ’s Balance-Sheet Equation 14
Recording Entries Using the Balance-Sheet Equation 18
Determine What Happened 18
Identify the Accounts 19
Determine the Account Signs 20
Determine the Entry Signs 21
Record the Entry 21
Check Quality 22
Viewing Account Activity Using BSE Matrix 23
Recording Entries Using Journal Entries 23
Determine Whether the Account is a Debit or Credit Account 24
Determine if Account is Debited or Credited 25
Record the Entry 25
Check Quality 26
Viewing Account Activity Using T-Accounts 26
Record Keeping Summary Table 27
ABC Company Example  29
Exercise 1.02 34

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2 Navigating Accounting

Judgments Behind the Numbers 36


Decision Making Hierarchy 37
Recognition Decisions 38
Measurement Decisions 40
Classification Decisions 43
Disclosure Decisions 44
Exercise 1.03 46
Exercise 1.04 47
Exercise 1.05 48
Exercise 1.06 49
Exercise 1.07 51
Exercise 1.08 53
Statement of Owners’ Equity 56
How Do I Use the Numbers?  58
Preparers’ and Users’ Perspectives of R&R Map  60
Exercise 1.09 62
Exercise 1.10 63
Exercise 1.11 64
Key Take-Aways 70
Figure 1.01 Intel’s Balance Sheet 74
Figure 1.02 Nike’s Balance Sheet 75
Figure 1.03 Federal Express’ Balance Sheet 76
Figure 1.04 Intel’s Common Size Balance Sheets 77
Figure 1.05 Gap’s Common Size Balance Sheets 78
Figure 1.06 Intel’s Statement of Stockholders’ Equity 79
Figure 1.07 Nike’s Statement of Stockholders’ Equity 80
Figure 1.08 Disney’s Statement of Owners’ Equity 81
Chapter Solutions 82
Solution to Exercise 1.01 82
Solution to Exercise 1.02 83
Solution to Exercise 1.03 86
Solution to Exercise 1.04 87
Solution to Exercise 1.05 88

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 3

Solution to Exercise 1.06 91


Solution to Exercise 1.07 93
Solution to Exercise 1.08 94
Solution to Exercise 1.09 96
Solution to Exercise 1.10 97
Solution to Exercise 1.11 98

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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4 Navigating Accounting

INTRODUCTION
In 1968, Bob Noyce and Gordon Moore founded Intel.
Shortly after, the new company created the first single-chip
microprocessor, which launched an information revolution that
has transformed virtually every aspect of our lives.
Like most entrepreneurs, Intel’s founders had few resources
when they started their company. For all practical purposes these
resources were little more than phenomenal ideas, immense
talent, and the courage to strike out on their own. Indeed, they
faced significant challenges and risks.
Among other tasks, they had to convince prospective employees,
suppliers, investors, and other stakeholders — those who have
an interest in the company’s success — that Intel’s ideas and its
strategy to implement them were financially attractive — that
Intel could earn enough money to compensate them for the risks
they were taking by investing in the new company.
When deciding whether to contribute resources, each stakeholder
had to assess Intel’s financial condition: What other resources
did Intel have? What cash could it generate from these resources?
What promises had Intel made to others? For example, did the
company already have loans it would have to repay?
By the end of this chapter, you’ll understand how Intel’s balance
sheets likely helped potential stakeholders assess its financial
condition during its start-up year, and how they continue to
help its current stakeholders do so today. You’ll also learn why
Intel’s recent balance sheets can tell us a great deal more about the
company’s financial condition than its start-up balance sheets.
Finally, you’ll learn that Intel was in great financial condition at
the end of 2007— well positioned to finance the research and
development of new ideas, implement strategies to bring these
ideas to market, weather temporary downturns in demand for its
products, and seize new opportunities.
The Intel story emphasizes how balance sheets can help insiders and
outsiders assess companies’ financial ability to execute their planned
strategies, meet their financial obligations, and respond quickly to
unforeseen opportunities and challenges.
We often think of balance sheets as pictures of a company’s financial
position on a specific date. However, they tend to be fuzzy pictures. In
fact, they are more like x-rays, MRIs, or ultrasound medical images than
clear photographs. For instance, like medical images, Intel’s balance
sheets only show us those aspects of the company’s financial condition
that we can measure reliably: a good deal of information about its

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 5

financial condition is missing or measured with varying degrees of


imprecision.
Also like medical images, balance sheets must be interpreted in their
broader context—in this case the company’s business (analogous to
the patient’s medical history). Still, just as medical images help doctors
make informed judgments about patients’ health, balance sheets, while
imperfect, do help insiders and outsiders make informed assessments
of companies’ financial condition. Finally, we often describe a firm’s
financial condition in health terms: a highly successful company is strong,
competitive, flexible, and adaptive. In contrast, the financial condition of
a failing company is weak, sick, inflexible, or on life support.
Let’s introduce balance-sheet terms and concepts using Bischoff Global
Sportswear (BGS), a fictitious retail merchandising company. BGS
purchases trendy sportswear from companies throughout the world and
resells them to retail clothing stores. We will be using BGS throughout
Navigating Accounting to illustrate terms, concepts and processes.

WHAT DO YOU SEE?


What do you see when you look at a balance sheet? Balance sheets are
organized in a hierarchy and a good way to navigate them is to follow this
hierarchy.
The top of the hierarchy is the primary balance-sheet classes: assets,
liabilities and owners’ equity and a balance sheet’s defining structure is the
balance sheet equation:

Balance-Sheet Equation

A L OE
= Liabilities +
Assets Owners' Equity

Thus, the first thing you should notice when analyzing BGS’s 2013
balance sheet (at the top of the next page) is that it does indeed balance:
$940 Assets = $327 Liabilities + $613 Owners’ Equity
Specifically, you should examine the extent to which the company’s
assets exceed the liabilities; that is, the company’s net assets. The larger
the net assets, the more likely it will be that the company will meet its
obligations, even in the event some assets’ benefits are not fully realized
because of unforeseen circumstances. Bischoff has nearly three times
as many assets as it has liabilities at the end of 2013. Thus, providing
the expected future benefits associated with the assets are realized, it

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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6 Navigating Accounting

BISCHOFF GLOBAL SPORTSWEAR


STATEMENTS OF FINANCIAL POSITION

December 31, 2013 and December 31, 2012

(In Millions)
Assets 2013 2012
Current
Cash and cash equivalents $31 $13
Accounts receivable, net 106 78
Inventories 147 103
Other current assets 229 178
Total current assets 513 372
Non-current
Property, plant, and equipment, net 194 175
Other non-current assets 233 199
Total non-current assets 427 374
Total assets $940 $746

Liabilities and Stockholders' Equity


Liabilities
Current
Accounts payable 25 35
Other current liabilities 97 95
Total current liabilities 122 130
Non-current
Long-term borrowings 105 60
Other non-current liabilities 100 70
Total non-current liabilities 205 130
Total liabilities 327 260
Stockholders' equity
Share capital 253 214
Other stockholders' equity 360 272
Total stockholders' equity 613 486
Total liabilities and stockholders' equity $940 $746

would appear that Bischoff should have no difficulty meeting its future
obligations. However, we are assuming the assets’ benefits will be realized
in time to meet the obligations, which may not be true.
To gain insights about the relative timing of the benefits and obligations,
we need to examine the second level of the balance-sheet hierarchy: Assets
and liabilities are each divided into two categories that center on timing.
Assets are classified as current if benefits are expected within one year
and non-current if the benefits are expected beyond one year. Similarly,
liabilities are current if obligations must be met within one year and non-
current if obligations are due beyond one year.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 7

Bischoff reports total current assets of $513 at the end of 2013.


Companies always report this subtotal. Companies such as BGS that
comply with International Financial Reporting Standards (IFRS) must
also report total non-current assets. Companies such as Intel that comply
with US GAAP are not required to report this line item.
Bischoff reports total current liabilities of $122 at the end of 2013.
Companies always report this subtotal too and those complying with
IFRS must also report total non-current liabilities.

BISCHOFF GLOBAL SPORTSWEAR


STATEMENTS OF FINANCIAL POSITION

December 31, 2013 and December 31, 2012

(In Millions)
Assets 2013 2012
Current
Cash and cash equivalents $31 $13
Accounts receivable, net 106 78
Inventories 147 103
Other current assets 229 178
Total current assets 513 372
Non-current
Property, plant, and equipment, net 194 175
Other non-current assets 233 199
Total non-current assets 427 374
Total assets $940 $746

Liabilities and Stockholders' Equity


Liabilities
Current
Accounts payable 25 35
Other current liabilities 97 95
Total current liabilities 122 130
Non-current
Long-term borrowings 105 60
Other non-current liabilities 100 70
Total non-current liabilities 205 130
Total liabilities 327 260
Stockholders' equity
Share capital 253 214
Other stockholders' equity 360 272
Total stockholders' equity 613 486
Total liabilities and stockholders' equity $940 $746

Notice that Bischoff ’s $513 of current assets far exceeds its $122 of
current liabilities. Thus, providing these current assets can be converted
to cash in time to meet the obligations associated with the current
liabilities, it appears Bischoff will meet these obligations and have

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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8 Navigating Accounting

additional cash to support its growth plans or survive unexpected


downturns in demand for its products.
This argument also seems to extend beyond one year: Bischoff ’s non-
current assets will likely provide additional cash flows to support long-
term growth or unexpected downturns.
Our tentative conclusion at this stage of our analysis is that Bischoff
has a healthy balance sheet. This assumes that the benefits associated
with Bischoff ’s assets will be realized in time to meet the obligations.
However, we do not know what the assets are and thus can not assess the
risks that their future benefits will not be realized.
To begin to gain this knowledge, we need to examine the third level of
the balance-sheet hierarchy: line items. Bischoff reports four line items
for current assets: cash, accounts receivable, inventories, and other assets.

Assets 2013 2012


Current
Cash and cash equivalents $31 $13
Accounts receivable, net 106 78
Inventories 147 103
Other current assets 229 178
Total current assets 513 372

Let’s examine how quickly these assets can be converted to cash and
the risks that their benefits will not be realized —asset risk. This is the
risk that the value of an entity’s assets will decline under various dire
assumptions about future economic conditions. For example, companies
that own significant stock in other companies have more asset risk than
companies that have comparable investments in government securities.
Similarly, companies that have high proportions of receivables relative to
cash are generally more risky than otherwise comparable companies that
have low proportions of receivables to cash. However, to assess this credit
risk and, more generally, to evaluate companies’ future prospects, users
need to combine financial statement information with information they
get from several other sources.
They also need to identify the risks of individual line items and assess
the interdependencies across these risks. And, they need to understand
what the expected benefits are for individual assets so they can assess the
risk these benefits will not be realized. So what are the benefits associated
with the current assets disclosed on Bischoff ’s balance sheet (above) and
how risky are they?

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 9

You already know cash is money. Cash equivalents are short-term


investments readily convertible to known amounts of cash and there is
almost no risk that these benefits will not be realized. Cash equivalents are
Drill Deeper
said to be highly liquid, meaning they can easily be converted to cash. For
To learn more about
balance-sheet line
example, a company might buy a 3-month certificate of deposit (or CD)
items see the reference to earn interest during the 3-months. CDs can be converted to cash easily
document: Line-by-Line so the company would classify them as cash equivalents. While companies
Tour: Intel’s Financial
Statements on the
typically report a single line item of cash and cash equivalents, users of
Navigating Accounting CD financial statements generally refer to this line as “cash”.
or back of course pack.
Accounts receivable are amounts expected to be collected from customers
for goods or services sold “on account” rather than with cash. Sales
on account occur when customers purchase products in exchange for
promised future payments. Bischoff expects to collect $106 from its
customers during 2014 when customers fulfill their obligation to pay for
the goods or services they purchased on account. The risks associated with
such collections can vary considerably across business contexts, depending
on the financial health of companies’ customers. This is especially true
during downturns in the economy.
Inventories are assets purchased or produced with the intent to sell them
to customers as products. Bischoff produces most of its inventories and
purchases other merchandise from suppliers. Inventories are generally
riskier than receivables and less liquid because there is a risk that
their sales prices will need to be reduced and there is still the risk that
these sales will not be collected. Bischoff ’s other current assets will be
introduced in future chapters.
Bischoff reports two non-current asset line items: property, plant and
equipment and other long-term assets, which will be discussed in later
chapters.

Assets 2013 2012


Non-current
Property, plant, and equipment, net 194 175
Other non-current assets 233 199
Total non-current assets 427 374
Total assets $940 $746

Property, plant and equipment includes assets purchased or created to


support day-to-day operations of the company. For example, Bischoff ’s
property, plant & equipment includes land, buildings, office furniture
and computers. This line item is also called PP&E for short.
Classification of assets as PP&E depends on the way the assets will be
used. For example, land is PP&E for most companies, but inventory for

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
10 Navigating Accounting

real estate companies that buy and sell land. Similarly, computers are
inventories for companies that sell computers to customers, but PP&E
when the computers are used to run the business.
The risks and liquidity associated with PP&E depend greatly on the
assets and business context. For example, cars are much more liquid
than highly specialized equipment because there is an active market for
buying and selling used cars.
Bischoff ’s balance sheet reports two current liabilities: accounts payable
and other current liabilities introduced in later chapters.

2013 2012
Liabilities
Current
Accounts payable 25 35
Other current liabilities 97 95
Total current liabilities 122 130

Accounts payable are amounts owed to suppliers and others for resources
purchased on account. These are current liabilities so Bischoff has an
obligation to pay them in the near future.
Companies often delay paying accounts payable as long as possible
either because they do not have enough cash or they are using cash for
other purposes. Often the reason they do not have enough cash to pay
their payables is because they can’t collect cash owed by their customers
as receivables. This can lead to a ripple effect that spreads through the
economy and, in fact, this is what happened in part during the credit
crisis of 2007-2010.
Bischoff reports two non-current liabilities: long-term debt and other
long-term liabilities introduced in later chapters.

2013 2012
Liabilities
Non-current
Long-term borrowings 105 60
Other non-current liabilities 100 70
Total non-current liabilities 205 130

Long-term debt includes loans or obligations for a fixed amount (called


principal) that is required to be paid, along with interest, by a maturity
date one or more years from the date the loan was issued. Examples
include mortgages and long-term bank loans.
When companies anticipate making long-term debt payments within
the next year, they are required to reclassify these planned payments as

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 11

current liabilities. This helps outsiders better assess whether the company’s
current assets will meet its current obligations.
Bischoff reports two owners’ equity line items: share capital and other
stockholders’ equity introduced in later chapters.

2013 2012
Stockholders' equity
Share capital 253 214
Other stockholders' equity 360 272
Total stockholders' equity 613 486

Share capital reports the historical cost of the contributions shareholders


have made in exchange for common stock, possibly net of the cost of
repurchased shares (depending on how the company accounts for share
repurchases, as discussed in a later chapter). Synonyms include paid in
capital and issued capital.

Key Take Aways


You should view balance sheets at three levels:
1. Start with the totals for the three primary balance-sheet
classes — assets, liabilities, and owners’ equity. For
example, examine the extent to which the company’s
assets exceed the liabilities; that is, the company’s net
assets. The larger the net assets, the more likely the
company will meet its obligations, even in the event some
assets’ benefits are not fully realized because of unforeseen
circumstances.
2. At the second level, examine the totals for the current and
non-current assets and liabilities to determine whether the
timing of the expected benefits from the company’s assets
are aligned with the timing of the company’s obligations,
either in the near term or longer term. For instance,
determine if the company has sufficient current assets that
it can convert to cash to meet its current liabilities.
3. At the third level, examine the individual balance-sheet
line items to refine your assessment of the timing and
gauge the likelihood that the benefits associated with the
assets will be realized in time to meet the obligations.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
12 Navigating Accounting

Exercise 1.01
This question pertains to Intel’s balance sheet on page 74 (Figure 1.01).
Check your solution at the top of page 82.
Hint: As needed, reference Line-by-Line Tour: Intel
Search Icon Financial Statements. This can be found on the Navigating
This exercise requires you
Accounting CD or a back section of your course packet.
to search for information. (a) Complete the following table for Intel:

Owners'
Assets = Liabilities +
equities

Intel
= +
year-end 2006

Intel
= +
year-end 2007

(b) Complete the following table for Intel:

Current Non-current Current Non-current Owners'


+ = + +
assets assets liabilites liabilities equities

Intel
+ = + +
year-end 2006

Intel
+ = + +
year-end 2007

(c) True or False: At the end of 2007, Intel owes debtors $8,571 that
must be paid within one year.
(d) True or False: At the end of 2007, Intel recognizes $23,885 of assets
that it expects to realize benefits from in the near future.
(e) True or False: Intel is a debtor to at least one government at the end of
2007 because it recognizes $339 of income taxes payable.
(f ) True or False: Intel’s balance sheet recognizes a total of $42,762 of
equity claims at the end of 2007.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 13

WHAT’S BEHIND THE NUMBERS?


Framing Record Keeping and Reporting
You already know three levels at which you can analyze balance sheets
based on what you see on the surface of the statement. But, what’s
behind the numbers and how can the answer help you gain a deeper
understanding of how the numbers reflect the underlying business?
In this section, you will learn about accounts and entries behind the
numbers and how knowing them can help you understand the reasons
balance-sheet’s line item numbers changed during the year.
Entries are the way accountants collect and organize information
associated with the events and circumstances that occurred in the business
during the reporting period. Entries record the financial impact of these
activities into storage areas called accounts, which aggregate the entries
recorded into them during each reporting period.
To understand entries’ importance, consider that large global companies
record billions of entries each year and every one of these affects their
balance sheet. Fortunately, users of financial statements, or others learning
how to prepare financial statements, don’t need to know all of these
entries. Still, they need a model that captures the essential features of the
accounting systems companies use.
We will use such a model that is relatively easy to grasp because it is
based on the simple principle that entries must be recorded in a manner
that ensures that the balance-sheet equation is always mathematically
balanced: the balance-sheet-equation model or BSE model for short.
Accounts
Companies can have thousands of accounts and thus they need to
organize them so accountants can consistently use the correct accounts
when recording entries. This is accomplished by creating a chart of
accounts organized using the balance-sheet hierarchy.
Bischoff ’s chart of accounts (top of next page) is organized first
by balance sheet classification and then alphabetically. It contains
abbreviated labels, such as AR for accounts receivable and C for cash. The
“other” accounts listed in the chart will be introduced in later chapters as
we discuss new entries.
This is an abbreviated version of of Bischoff ’s chart of accounts. We chose
a few accounts to help you learn basic concepts and procedures. We also
include “other” accounts for balance sheet categories such as current and
noncurrent assets and current and noncurrent liabilities.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
14 Navigating Accounting

BISCHOFF GLOBAL SPORTSWEAR


CHART OF ACCOUNTS
ASSETS
Current
AR Accounts receivable
C Cash and cash equivalents
Inven Inventories
OCA Other current assets
Non-current
PPE Property, plant, and equipment, net
ONCA Other non-current assets
LIABILITIES

Current
AP Accounts payable
OCL Other current liabilities
Non-current
LTD Long-term debt
ONCL Other non-current liabilities
OWNERS' EQUITY

Permanent
SCap Share capital
OPOE Other permanent owners' equity

When analyzing Bischoff, “other” accounts and “other” entries play a


central role in our strategy to help you learn how to interpret financial
statement numbers. Envision how gigantic the equation would become if
we were to replace “other” with Intel’s thousands of accounts.
Fortunately, this is not necessary because the related concepts are fully
scalable: if you understand a concept when few accounts are included in
the equation, you will understand extensions of these concepts when all
accounts are included.
Bischoff’s Balance-Sheet Equation
Bischoff ’s accounts are connected by the balance-sheet equation (BSE):

Balance Sheet Equation with Accounts

Assets = Liabilities + Owners' Equity

Current + Noncurrent = Current + Noncurrent +

+ C + AR + Inven + OCA + PPE + ONCA = + AP + OCL + LTD + ONCL + PIC + OPOE

Connecting Reported Numbers to Entries


When analyzing BGS’s balance sheets as an outsider, we would like to
understand the reasons reported items changed during the year. For

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Chapter 1: Introduction to Balance Sheets 15

example, why did accounts payable decrease by $10 during 2013 (from
$35 to $25)? Because balance sheets must balance, we know this $10
decrease must have affected one or more other balance-sheet line items.
But, which ones, and how did they change?

2013 2012
Liabilities
Current
Accounts payable 25 35
Other current liabilities 97 95
Total current liabilities 122 130

The answers to these questions are found in the balance-sheet-equation


matrix below. Before addressing them, we will explain four key features of
the matrix using an account you are familiar with — cash:
• The columns contain numbers associated with specific accounts,
starting with cash in the first column (as highlighted below).
• The first and last rows report beginning and ending balances. The
other rows report entries that explain changes in accounts. These will
be discussed shortly.
• Each number has two signs that will be defined shortly.

Figure Colors • The first and last rows contain numbers on BGS’s balance sheet.
Use the PDF version
This is illustrated with color coding in the Record Keeping and
of this chapter on your Reporting Map on the next page. Study this map very carefully now
Navigating Accounting CD and return to it as needed.
to zoom in and see the
color-coded figures.

Owners'
Assets = Liabilities +
Equity

Current + Non-current = Current + Non-current + Permanent

+ C + AR + Inven + OCA + PPE + ONCA = + AP + OCL + LTD + ONCL + SCap + OPOE


December 31, 2012 + + $13 + + $78 + + $103 + + $178 + + $175 + + $199 = + + $35 + + $95 + + $60 + + $70 + + $214 + + $272

E1 Issued share capital for cash + + 10 + + + + + = + + + + + + 10 +


Period Entries

E2 Issued non-current debt for cash + + 10 + + + + + = + + + + 10 + + +

E3 Purchased PP&E with cash + - 20 + + + + + 20 + = + + + + + +

E4 Purchased merchandise for resale + + + + 80 + + + = + + 80 + + + + +

E5 Paid invoices due + - 225 + + +0 + + + = + - 225 + + + + +

Other period entries + + 243 + + 28 + - 36 + + $51 + -1 + + 34 = + + 135 + + $2 + + 35 + + 30 + + 29 + - 25


December 31, 2013 + + $31 + + $106 + + $147 + + $229 + + $194 + + $233 = + + $25 + + $97 + + $105 + + $100 + + $253 + + $360

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
16 Navigating Accounting

Figure Colors
Use the PDF version
of this chapter on your
Navigating Accounting CD
to zoom in and see the
color-coded figures.

Record-Keeping & Reporting Map


(Phase 1)
Owners'
Assets = Liabilities +
Equity

Current + Non-current = Current + Non-current + Permanent


+ C + AR + Inven + OCA + PPE + ONCA = + AP + OCL + LTD + ONCL + SCap + OPOE
December 31, 2012 + + $13 + + $78 + + $103 + + $178 + + $175 + + $199 = + + $35 + + $95 + + $60 + + $70 + + $214 + + $272

E1 Issued share capital for cash + + 10 + + + + + = + + + + + + 10 +


Period Entries

E2 Issued non-current debt for cash + + 10 + + + + + = + + + + 10 + + +

E3 Purchased PP&E with cash + - 20 + + + + + 20 + = + + + + + +

E4 Purchased merchandise for resale + + + + 80 + + + = + + 80 + + + + +

E5 Paid invoices due + - 225 + + + + + = + - 225 + + + + +

Other period entries + + 243 + + 28 + - 36 + + $51 + -1 + + 34 = + + 135 + + $2 + + 35 + + 30 + + 29 + - 25


December 31, 2013 + + $31 + + $106 + + $147 + + $229 + + $194 + + $233 = + + $25 + + $97 + + $105 + + $100 + + $253 + + $360

BISCHOFF GLOBAL SPORTSWEAR


STATEMENTS OF FINANCIAL POSITION

December 31, 2013 and December 31, 2012

(In Millions)
Assets 2013 2012
Current
Cash and cash equivalents $31 $13
Accounts receivable, net 106 78
Inventories 147 103
Other current assets 229 178
Total current assets 513 372
Non-current
Property, plant, and equipment, net 194 175
Other non-current assets 233 199
Total non-current assets 427 374
Total assets $940 $746

Liabilities and Stockholders' Equity


Liabilities
Current
Accounts payable 25 35
Other current liabilities 97 95
Total current liabilities 122 130
Non-current
Long-term borrowings 105 60
Other non-current liabilities 100 70
Total non-current liabilities 205 130
Total liabilities 327 260

Stockholders' equity
Share capital 253 214
Other stockholders' equity 360 272
Total stockholders' equity 613 486
Total liabilities and stockholders' equity $940 $746

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 17

Focusing on the accounts payable column (highlighted below), we see the


$10 decrease in the account is explained by three entries:
+80 The accounts payable liability increases $80 when BGS purchases
inventory from suppliers on account (E4) because BGS is
obligated to pay suppliers this amount in the future. This also
increases inventory by $80, which keeps the equation balanced.
-225 The accounts payable liability decreases by $225 when BGS pays
suppliers (E5) because BGS meets part of its obligation to them.
Accordingly, this entry decreases cash $225.
+135 The net effect of other 2013 entries on accounts payable is $135.
As indicated below, collectively they affect all of BGS’s accounts.
Some big lessons emerge from our discussion thus far:
• Outsiders observe the numbers in the first and last rows of
the matrix, but only when these are separately disclosed
on balance sheets or in footnotes. Accounts are frequently
combined on balance sheets: companies typically have
thousands of accounts but fewer than 25 balance-sheet line
items. Still, the accounts in this chapter are widely disclosed.
• Generally, outsiders do not observe the entry numbers
(between the first and last rows). Sometimes these are
reported in footnotes or can be derived or estimated reliably.
• When entry numbers can’t be estimated reliably, often their
impacts on accounts’ year-to-year changes can be gauged
qualitatively. For example, absent information to the contrary,
sometimes it is reasonable to assume purchases on account
and supplier payments have dominant impacts on accounts
payable while other entries have minor impacts.

Owners'
Assets = Liabilities +
Equity

Current + Non-current = Current + Non-current + Permanent

+ C + AR + Inven + OCA + PPE + ONCA = + AP + OCL + LTD + ONCL + SCap + OPOE


December 31, 2012 + + $13 + + $78 + + $103 + + $178 + + $175 + + $199 = + + $35 + + $95 + + $60 + + $70 + + $214 + + $272

E1 Issued share capital for cash + + 10 + + + + + = + + + + + + 10 +


Period Entries

E2 Issued non-current debt for cash + + 10 + + + + + = + + + + 10 + + +

E3 Purchased PP&E with cash + - 20 + + + + + 20 + = + + + + + +

E4 Purchased merchandise for resale + + + + 80 + + + = + + 80 + + + + +

E5 Paid invoices due + - 225 + + +0 + + + = + - 225 + + + + +

Other period entries + + 243 + + 28 + - 36 + + $51 + -1 + + 34 = + + 135 + + $2 + + 35 + + 30 + + 29 + - 25


December 31, 2013 + + $31 + + $106 + + $147 + + $229 + + $194 + + $233 = + + $25 + + $97 + + $105 + + $100 + + $253 + + $360

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
18 Navigating Accounting

Recording Entries Using the Balance-


Sheet Equation
You are now ready to learn how to record entries. Acquiring this skill will
help you analyze a specific balance-sheet line item, as we just did with
accounts payable. But more importantly, it will help you relate a change
in one line to other lines on the balance sheet.
For example, when Bischoff paid suppliers $225 for sportswear previously
purchased on account, we saw that accounts payable decreased because
Bischoff no longer owed the suppliers this amount. But what also
happened? Cash also decreased by $225. Thus, two balance sheet line
items were affected by this one entry: Cash and accounts payable. The
two effects might seem obvious in this example, but often they are less
clear.
For instance, the Wall Street Journal had many articles on the billions of
dollars in write-downs from the credit crisis during 2008 – all of which
focused on the effects on companies’ assets. But what was the other
side of the entry? Analysts had to anticipate the other effects using their
understanding of accounting and recording entries.
You too can learn these skills to help you understand how balance sheet
numbers are related to each other and how they relate to numbers
reported on other financial statements. To this end, you can record entries
using the balance sheet equation by following a six-step process:
1. Determine what happened.
2. Identify the accounts.
3. Determine the signs of the accounts.
4. Determine the entry’s effect on the accounts.
5. Record entry.
6. Do a quality check.
To demonstrate this process, we will apply it to Bischoff ’s first entry in
2013: recording a $10 issuance of common stock.
Determine What Happened
This step determines what the company got and what it gave in return.
Think of this in terms of the balance sheet. For instance, did the
company get something with a future benefit (an asset), commit itself to
a future obligation (a liability), or offer a claim on ownership (owners’
equity)?

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 19

Bischoff ’s first entry involves a transaction between the company and


its shareholders. Transactions with external parties always involve an
exchange where the company gets something and gives something to the
external party.
When entries pertain to transactions with external parties, its helpful to
start by sketching a picture of what happened, such as this sketch of a
Bischoff stock transaction. Bischoff gave shareholders common stock,
which is an ownership claim or owners’ equity. Bischoff got cash, which
is an asset.

What did BGS give?


An ownership claim

Common stock

Bischoff Global Sportswear Bischoff’s Shareholders

What did BGS get?


Cash

In entry E1, Bischoff gave shareholders common stock, which is an


ownership claim in the form of owners’ equity. In return, the company
got $10 million of cash, an asset. Thus, we know two primary balance-
sheet classes were affected, assets and owners’ equity.
Understanding what happened before trying to record an entry is
essential. This entry is pretty simple; but, trying to record a complex
entry before figuring out what happened is a recipe for disaster.
Identify the Accounts
The second step in recording an entry is to identify the accounts affected
by the entry. To find the accounts, search strategically through the chart
of accounts, starting with the primary balance sheet classes.
We know Bischoff gave its shareholders an ownership claim, so start
by focusing on owners’ equity. The most appropriate account (in the
chart of accounts at the top of the next page is share capital (SCap). You
might be thinking the account should be called common stock because
we are issuing common stock. Not necessarily true. Many companies,
including Bischoff, record common stock issuances into accounts called

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
20 Navigating Accounting

BISCHOFF GLOBAL SPORTSWEAR


CHART OF ACCOUNTS
ASSETS
Current
AR Accounts receivable
C Cash and cash equivalents
Inven Inventories
OCA Other current assets
Non-current
PPE Property, plant, and equipment, net
ONCA Other non-current assets
LIABILITIES

Current
AP Accounts payable
OCL Other current liabilities
Non-current
LTD Long-term debt
ONCL Other non-current liabilities
OWNERS' EQUITY

Permanent
SCap Share capital
OPOE Other permanent owners' equity

share capital, paid-in capital, common stock, or issued capital. This is the
portion of owners’ equity attributable to resources, such as cash, that have
been contributed to the company in exchange for stock.
To balance the balance sheet equation, every transaction affects at least
two accounts. Here, recall that we got an asset, a current asset, cash, as
part of the common stock transaction.
Determine the Account Signs
The third step in recording an entry is to determine the signs of the
accounts. In the balance-sheet equation, accounts are characterized as
accounts with either positive or negative account signs. A positive account
sign means the account increases its primary balance-sheet class and a
negative sign means the account decreases its primary balance sheet class.
We will study negatively signed accounts in a later chapter.
For entry E1, the signs of both accounts are positive.
• Cash’s sign is positive because cash increases assets.
• Share capital’s sign is positive because share capital increases owners’
equity.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 21

Owners'
Assets = Liabilities +
Equity

Current + Non-current = Current + Non-current + Permanent

+ C + AR + Inven + OCA + PPE + ONCA = + AP + OCL + LTD + ONCL + SCap + OPOE


December 31, 2012 + + $13 + + $78 + + $103 + + $178 + + $175 + + $199 = + + $35 + + $95 + + $60 + + $70 + + $214 + + $272

E1 Issued share capital for cash + + + + + + = + + + + + +


Period Entries

E2 Issued non-current debt for cash + + + + + + = + + + + + +

E3 Purchased PP&E with cash + + + + + + = + + + + + +

E4 Purchased merchandise for resale + + + + + + = + + + + + +

E5 Paid invoices due + + + + + + = + + + + + +

Other period entries + + + + + + = + + + + + +

December 31, 2013 + + + + + + = + + + + + +

Keep in mind, accounts’ signs never change, regardless of whether a


specific entry adds or subtracts from the account. So, a positively signed
account, such as cash, is always positively signed even though some
entries increase cash, such as issuing stock, and others decrease cash, such
as paying suppliers. When we study income statements, we will introduce
accounts on both sides of the equation that have negative signs.
Determine the Entry Signs
The fourth step in recording an entry is to determine how the entry
affects each account. Should the accounts increase or decrease due to the
events or circumstances that you identified in Step 1? A positive entry
sign means the entry increases the account balance and a negative entry
sign means the entry decreases the account balance.
Issuing stock increased cash so the entry sign is + for cash. Share capital
increased when Bischoff issued stock because the value of the owners’
claim increased. Thus, the entry sign for share capital is also +.
Record the Entry
The fifth step is to write the entry. This is easy to do once the first four
steps are completed. You simply enter the numbers associated with the
event into the appropriate accounts, along with their entry signs.

Owners'
Assets = Liabilities +
Equity

Current + Non-current = Current + Non-current + Permanent

+ C + AR + Inven + OCA + PPE + ONCA = + AP + OCL + LTD + ONCL + SCap + OPOE


December 31, 2012 + + $13 + + $78 + + $103 + + $178 + + $175 + + $199 = + + $35 + + $95 + + $60 + + $70 + + $214 + + $272

E1 Issued share capital for cash + + 10 + + + + + = + + + + + + 10 +


Period Entries

E2 Issued non-current debt for cash + + + + + + = + + + + + +

E3 Purchased PP&E with cash + + + + + + = + + + + + +

E4 Purchased merchandise for resale + + + + + + = + + + + + +

E5 Paid invoices due + + + + + + = + + + + + +

Other period entries + + + + + + = + + + + + +

December 31, 2013 + + + + + + = + + + + + +

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
22 Navigating Accounting

As we learn about and add more accounts to the BSE matrix, it will
become too large to fit across the page. Hence, we need a simpler template
that represents the full balance-sheet-equation matrix. We need a mini
matrix.
This mini matrix is derived by eliminating rows and columns from the
full balance-sheet-equation matrix that do not pertain to the entry. We
merely retain the entry’s primary balance sheet classes, accounts, account
signs, entry signs, equal signs, and recorded numbers.

Owners'
Assets = Liabilities +
Equity

Current + Non-current = Current + Non-current + Permanent

+ C + AR + Inven + OCA + PPE + ONCA = + AP + OCL + LTD + ONCL + SCap + OPOE


December 31, 2012 + + $13 + + $78 + + $103 + + $178 + + $175 + + $199 = + + $35 + + $95 + + $60 + + $70 + + $214 + + $272

E1 Issued share capital for cash + + 10 + + + + + = + + + + + + 10 +


Period Entries

E2 Issued non-current debt for cash + + 10 + + + + + = + + + + 10 + + +

E3 Purchased PP&E with cash + - 20 + + + + + 20 + = + + + + + +

E4 Purchased merchandise for resale + + + + 80 + + + = + + 80 + + + + +

E5 Paid invoices due + - 225 + + +0 + + + = + - 225 + + + + +

Other period entries + + 243 + + 28 + - 36 + + $51 + -1 + + 34 = + + 135 + + $2 + + 35 + + 30 + + 29 + - 25


December 31, 2013 + + $31 + + $106 + + $147 + + $229 + + $194 + + $233 = + + $25 + + $97 + + $105 + + $100 + + $253 + + $360

Thus, when we record the mini matrix for this entry, we are capturing the
elements of the full matrix that were impacted by the entry as shown here.

E1 Issued share capital for cash

Assets = Owners' Eq.

+ C = + SCap

+ + $10 = + + $10

Check Quality
The sixth and final step in recording an entry is to run a few simple
quality checks to help you avoid careless errors.
To check quality, ask the following questions about the transaction:
• Does the entry reflect what happened? The most common error is
to record an entry before you understand what happened. If you
don’t understand what happened or misunderstand the situation, it is
impossible to accurately reflect the business activity in the accounting
entry.
• Does the entry affect at least two or more accounts? Based on your
analysis of what happened, make sure you consider what the company
got and what it gave in return.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 23

• Does each number have two signs in the correct order? The first
is the account sign, which is the same for all entries recorded into
the account, and second is the entry sign, which indicates how
the entry affects the account balance. The order is not important
mathematically, but it is very important for accounting purposes.
• Does the net effect of these two signs correctly affect the related
primary balance sheet class? For example, does the net effect of the ++
$10 cash entry correctly reflect how the entry affected assets?
• Does the equation balance mathematically? Did you include an equal
sign in the appropriate place? Some students forget the equal sign or
put it in the wrong place in the equation.
• Once you know the equation is correct, does the right side of the
equation equal the left side? If not, start by re-checking the account
and entry signs from steps three and four.

Viewing Account Activity Using BSE


Matrix
The balance-sheet equation matrix can be used at the end of a reporting
period to view all the account activity within a column, which can be
summed to determine the account’s ending balance.

Recording Entries Using Journal Entries


There are two prevalent models for learning record keeping:
1. Balance-sheet-equation model: This relatively new model is
quickly gaining popularity because it is grounded in concepts that
most of us learned in the first few weeks of high school algebra. This
is the model we have been using thus far and will use throughout
Navigating Accounting.
2 Journal-entry or debit/credit model: This approach dates to the
fifteenth century, before there were negative numbers, but it has a
large installed base of users who communicate in debits and credits.
You can think of these models as two languages that describe how
information about events is entered and stored in accounting systems.
They are remarkably similar and, as we shall see, the translation to get
from one language to the other has three simple rules.
So why learn how to record entries using debits and credits? This is
the language spoken by the vast majority of people in the business
community. This likely includes your future bosses. Thus, it is to your
benefit to effectively communicate using the debits/credits model.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
24 Navigating Accounting

We will explain how to convert balance-sheet equation entries to debits


and credits journal entries using the same example we studied earlier:
recording Bischoff ’s $10 issuance of common stock (entry E1). In
addition, we will explain how to use T-accounts, rather than columns in
the BSE matrix, to view the effects of journal entries on accounts.
Since we are converting entry E1, let’s start where we left off after we
completed the six-step process for recording entries using the balance-
sheet equation. In particular, we left after we passed the quality checks. To
correctly convert a balance-sheet equation entry to debits/credits journal
entry, you should go through all six steps and make sure you pass the
quality checks. For example, if you have incorrectly determine account
sign, you will get your debits and credit backwards!
Here is the mini matrix we created for entry E1:

E1 Issued share capital for cash

Assets = Owners' Eq.

+ C = + SCap

+ + $10 = + + $10

Determine Whether the Account is a Debit or


Credit Account
First, we characterize each account as either a debit or credit account:
• An account on the left side of the balance-sheet equation with a
positive account sign is a debit account. In entry E1, cash (C) is an
account on the left side of the equation with a positive account sign so
cash is a debit account.
• An account on the right side of the balance-sheet equation with a
positive account sign is a credit account. In entry E1, share capital
(SCap) is an account on the right side of the equation with a positive
account sign so SCap is a credit account.
Later, we will study accounts that have negative account signs. To
characterize these accounts use the following:
• An account on the left side of the balance-sheet equation with a
negative account sign is a credit account.
• An account on the right side of the balance-sheet equation with a
negative account sign is a debit account.
Characterizing the account is a critical step in properly recording an entry;
however, the characterization does not change when recording different

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 25

entries. A debit (credit) account is always a debit (credit) account


irrespective of the entry. This is analogous to the account sign that
doesn’t change when recording different entries.
Similarly, this debit (credit) characterization is an adjective that describes
the type of account just as the account sign is an adjective that describes
the account in the balance-sheet equation approach.
Determine if Account is Debited or Credited
Now we need to determine how the entry affects the accounts. This
step determines whether the accounts are debited or credited (verb) by
converting the balance-sheet equations’ entry sign. For entry E1, both
accounts have positive entry signs indicating the entry increases each
account.

E1 Issued share capital for cash

Assets = Owners' Eq.

+ C = + SCap

+ + $10 = + + $10

Converting to debits or credits:


• An increase to a debit account is a debit to the account. In entry E1,
cash (C) is increased as indicated by the positive entry sign. Earlier
we determined that cash is a debit account so this entry debits the
cash account.
• An increase to a credit account is a credit to the account. In entry
E1, share capital (SCap) is increased as indicated by the positive entry
sign. Earlier we determined that paid-in capital is a credit account so
this entry credits the SCap account.
Later, we will study entries with negative entry signs. In these entries:
• A decrease to a debit account is a credit to the account.
• A decrease to a credit account is a debit to the account.
Thus, using the debits/credits language of accounting, we say cash is a
debit account (adjective). It is debited (verb) $10 when recording entry
E1. Share capital a credit account (adjective). It increased and thus it is
credited (verb) $10.
Record the Entry
While balance sheet equation entries are recorded in the balance-sheet
equation matrix or the mini matrix, debit and credit entries are recorded
in journal entries.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
26 Navigating Accounting

The figure below illustrates the journal entry format for E1:
• There is a separate row for each account in the entry.
• The accounts that are debited are listed first (regardless if they are a
debit or credit accounts).
• Then the accounts that are credited are listed, indented slightly to the
right.
• The amounts are reported in two columns to the right
with the credits column the farthest to the right.

E1 Issued share capital for cash

Debit Credit

Cash and cash equivalents $10

Share capital $10

Check Quality
Just like balance sheet equation entries there are a few simple accuracy
checks for debit and credit entries recorded in journal entries.
• Are the debits and credits properly indicated in the journal entry
format? For example, did you list the accounts that are debited first?
• Are the sum of the debits equal to the sum of the credits? This is an
especially valuable check whenever there is more than two accounts.

Viewing Account Activity Using T-Accounts


The balance-sheet equation matrix can be used the end of a reporting
period to view all the account activity within a column, which can be
summed to determine the account’s ending balance.
However, with the debits/credits approach, journal entries must be
recorded into T-accounts (referred to as “posting”) to view all the account
activity and determine the account’s ending balance. T-accounts refer to
the shape. The figure on the next page demonstrates that each account
in the BSE matrix corresponds to a T-Account and it also highlights the
T-account conventions:
• Debit accounts’ T-accounts’ balances and increases are on the left
(debit) side of the accounts and their decreases are on the right
(credit) side of the accounts. For example, cash is a debit account, so
its balances and increases (debits) are on the left side of the account.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 27

Owners'
Assets = Liabilities +
Equity

Current + Non-current = Current + Non-current + Permanent

+ C + AR + Inven + OCA + PPE + ONCA = + AP + OCL + LTD + ONCL + SCap + OPOE


December 31, 2012 + + $13 + + $78 + + $103 + + $178 + + $175 + + $199 = + + $35 + + $95 + + $60 + + $70 + + $214 + + $272

E1 Issued share capital for cash + + 10 + + + + + = + + + + + + 10 +


Period Entries

E2 Issued non-current debt for cash + + 10 + + + + + = + + + + 10 + + +

E3 Purchased PP&E with cash + - 20 + + + + + 20 + = + + + + + +

E4 Purchased merchandise for resale + + + + 80 + + + = + + 80 + + + + +

E5 Paid invoices due + - 225 + + +0 + + + = + - 225 + + + + +

Other period entries + + 243 + + 28 + - 36 + + $51 + -1 + + 34 = + + 135 + + $2 + + 35 + + 30 + + 29 + - 25


December 31, 2013 + + $31 + + $106 + + $147 + + $229 + + $194 + + $233 = + + $25 + + $97 + + $105 + + $100 + + $253 + + $360

C SCap
BB $13 BB $214
E1 $10 E1 $10
E2 $10
E3 $20

E5 $225
oth $243 oth $29
EB $31 EB $253

• Credit accounts’ T-accounts’ balances and increases are on the right


(credit) side of the accounts and their decreases are on the left (debit)
side of the accounts. For example, share capital is a credit account,
so its balances and increases (credits) are on the right side of the
account.
This T-account perspective, plus the layout of journal entries, is the
rational for the definition of “debit” meaning on the left and “credit”
meaning on the right.

Record Keeping Summary Table


The chart at the top of the next page summarizes the way the two
models record entries and display account activity.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
28 Navigating Accounting

Comparison of Record-Keeping and Reporting Using the Balance-Sheet-Equation and Debits/Credits Models

Step Task Balance-Sheet Equation (BSE) Debits/Credits Converting BSE to Debits/Credits

Determine what
1 Describe business activity in terms of the primary balance sheet classes
happened

Identify the Search the chart of accounts, starting with the primary balance-sheet classes to identify the accounts
2
accounts affected

An account on the left side of the balance-


sheet equation with a positive account sign
Determine whether the
is a debit account
Characterize the accounts are debit or
3 Determine the accounts' signs
accounts credit accounts
Changing one (two) bold words in this
(noun)
sentence causes the italicized word to
change to a credit (stay a debit)

An increase to a debit account is a debit to


Recording Entries

Determine whether the the account


Determine entry Determine the entry signs — how accounts are debited or
4
affects on accounts the entry affected the accounts credited Changing one (two) bold words in this
(verb) sentence causes the italicized word to
change to a credit (stay a debit)

Record the entry using a BSE Record the entry using a


5 Record entries
equation journal entry

Does the entry reflect what


happend?

Does each number have two Does the entry reflect


signs? what happend?

Does the account sign (first sign Are the debits and
from the left) reflect how the credits properly indicated
6 Check quality
account affects its primary class? with the accounts
debited listed first?
Does the entry sign (second sign
from the left) reflect how the entry Are the total debits equal
affects the account? to the total credits?

Does the equation balance

An increase to a debit T-account is recorded


on the left side of the T-account
Viewing View period
Column in the BSE matrix T-Account
Activity account activity Changing one (two) bold words in this
sentence causes the italicized word to
change to a right (stay left)

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 29

ABC Company Example


ABC Company starts its first year of operations by recording the
following events (E1-E3). All amounts are in thousands of dollars.
E1: ABC’s shareholders contribute $1,000 of cash to ABC in exchange
for 1 million shares of ABC’s non-par common stock.
E2: ABC purchases a building from Kaplan Properties for $200 cash.
The building will be used as a store.
E3: ABC purchases $100 of merchandise from Healy Inc. on account
and plans to sell to customers for a profit.
The next few pages illustrate how these entries are recorded using the
BSE matrix and how these entries affect the balance sheet.
Event E1 — Issuing Common Stock
The entry to record issuing $1,000 of common stock in exchange for
cash is highlighted in the BSE matrix in the figure on the next page. The
numbers in the figure are color coded so you can see how they affect the
balance sheet, which reflects all three entries we will be studying in this
example, not just this entry.
How does the event affect the balance sheet?
• Assets, and in particular, cash, increase by $1,000. This reflects the
future benefits associated with the cash received from shareholders.
• Owners’ equity, and in particular, common stock, increases by
$1,000. This reflects the increase in the value of the owners’ claims
associated with issuing the stock.
The figure illustrates these two effects: $1,000 recorded into cash in the
BSE matrix traces to cash on the balance sheet and $1,000 recorded into
common stock traces to common stock on the balance sheet.
What would an outsider see?
Generally, even though the entry affects the balance sheet, an outsider
would not see the direct effects of this one entry because the balance
sheet aggregates the effects of other entries (from the current or past
periods). For example, ABC’s $800 ending cash balance is the net effect
of two entries that affected cash, as we will see when we study event E2.
An outsider would see the $1,000 effect of the entry on the common
stock line item. However, this would not be true if ABC had issued
common stock in prior years or if other entries affected common stock
during the current year.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
30 Navigating Accounting

Figure Colors As we introduce other statements in future chapters, we will see that
Use the PDF version additional information is available for an outsider to determine the cash a
of this chapter on your company receives from issuing common stock. So stay tuned.
Navigating Accounting CD
to zoom in and see the Take-aways
color-coded figures.
As an outsider, you only see the aggregate effects of entries
on balance-sheet line items, even though all entries affect
balance sheets.

Event E1 — Issuing $1,000 of common stock for cash


This balance sheet reflects all three entries we are studying in this example, not just this entry.
ABC Company Balance Sheet
After first three events in first year of operations

Assets End Bal Beg Bal


Current
Cash $800
0 $0
Inventories 100 0
Total current assets 900 0
Owners' Non-current
Assets = Liabilities + Property, plant and equipment 200 0
Equity
Total non-current assets 200 0
+ C + Inven + PPE = + AP + CS Total assets $1,100 $0
Beginning balances + + $0 + + $0 + + $0 = + + $0 + + $0
E1 + + + = + +
Liabilities and Stockholders' Equity
Issue stock for cash + 1,000 + 1,000
Entries
Period

Liabilities
E2 Purchase building with cash + - 200 + + + 200 = + +
Current
E3 Purchase inventory on account + + + 100 + = + + 100 + Accounts payable 100 0
Ending balances + + + = +
Total current liabilities 100 0
+ $800 + $100 + $200 + $100 + + $1,000
Non-current 0 0
Total liabilities 100 0
Stockholders' equity
Common stocks ock
st 1,000 0
Total stockholders' equity 1,000 0
Total liabilities and stockholders' equity $1,100 $0

E2 — Purchasing a Building
The entry to purchase a building is highlighted on the next page.
How does the event affect the balance sheet?
This event affects two assets:
• Cash decreases by $200, indicating the cash used to purchase the
building no longer provides future benefits to ABC.
• Property, plant, and equipment increases by $200, reflecting the
future benefits associated with the building: ABC can use the store
to sell products. Property, plant, and equipment (PP&E) includes
tangible assets purchased or created to support day-to-day operations.
The figure illustrates these effects: the $200 cash outflow traces to cash
on the balance sheet and the $200 increase in PP&E traces to property,
plant, and equipment.
Thus, this entry changes the asset composition of ABC’s balance sheet but
it does not change the total value of the assets or the value of the owners’
claims on these assets: $1,000.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 31

Event E2 — Purchasing a building for $200 cash


This balance sheet reflects all three entries we are studying in this example, not just this entry.
ABC Company Balance Sheet
After first three events in first year of operations

Assets End Bal Beg Bal


Cu e t
Current
Cash $800 $0
Inventories 100 0
Total current assets 900 0
Owners' Non-current
Assets = Liabilities + Pro
r pert
r y, plant and equipment
Property, 200 0
Equity
Total non-current assets 200 0
+ C + Inven + PPE = + AP + CS Total assets $1,100 $0
Beginning balances + + $0 + + $0 + + $0 = + + $0 + + $0
E1 Issue stock for cash + + 1,000 + + = + + + 1,000
Liabilities and Stockholders' Equity
Entries
Period

Liabilities
E2 Purchase building with cash + - 200 + + + 200 = + +
Current
E3 Purchase inventory on account + + + 100 + = + + 100 + Accounts payable 100 0
Ending balances + + $800 + + $100 + + $200 = + + $100 + + $1,000
Total current liabilities 100 0
Non-current 0 0
Total liabilities 100 0
Stockholders' equity
Common stock 1,000 0
Total stockholders' equity 1,000 0
Total liabilities and stockholders' equity $1,100 $0

What would an outsider see?


Again, even though the entry affects the balance sheet, an outsider would
typically not see the effect because it would be aggregated with the effects
of other entries (from the current or past periods).
An outsider would see the $200 impact of the entry on ABC’s balance
sheet because this is ABC’s first year of operations and E2 is the only
entry that affected property, plant, and equipment.
As we introduce other statements in future chapters, we will see that
additional information is available for an outsider to determine the net
cash a company spends for purchasing property, plant and equipment.
E3 —Purchasing Inventory on Account
The entry to record purchasing inventory on account is highlighted on
the next page.
How does the event affect the balance sheet?
This event increases both sides of the equation:
• On the left side of the equation, inventories increase by $100,
reflecting the future benefits ABC will receive from the inventories.
Inventories are assets companies buy or manufacturer with the intent
to sell them to customers as products.
• On the right side of the equation, the accounts payable increases by
$100, reflecting ABC’s obligation to pay for the inventories in the
future. Accounts payable is amounts owed to suppliers and other
creditors for raw materials and other resources purchased on account.

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32 Navigating Accounting

There are two balance sheet effects: the $100 recorded to inventories
(assets) traces to inventories on the balance sheet and the $100 recorded
to accounts payable (liabilities) traces to accounts payable. Thus, ABC
now has debt and owners’ equity claims on its assets.
What would an outsider see?
Typically, nothing. The entry’s effects are aggregated “behind the
numbers” reported on the balance sheet.
However, an outsider would see the $100 impact of the entry on ABC’s
balance sheet because this is ABC’s first year of operations and E3 is the
only entry that affects inventories and accounts payable.
In future chapters, we will introduce other statements where an outsider
can draw related inferences in some business contexts about a company’s
purchases of inventory on account.

Event E3 — Purchasing $100 of merchandise on account


This balance sheet reflects all three entries we are studying in this example.
ABC Company Balance Sheet
After first three events in first year of operations

Assets End Bal Beg Bal


Current
Cash $800 $0
Inve
v ntories
Inventories 100 0
Total current assets 900 0
Owners' Non-current
Assets = Liabilities + Property, plant and equipment 200 0
Equity
Total non-current assets 200 0
+ C + Inven + PPE = + AP + CS Total assets $1,100 $0
Beginning balances + + $0 + + $0 + + $0 = + + $0 + + $0
Liabilities and Stockholders' Equity
E1 Issue stock for cash + + 1,000 + + = + + + 1,000
Entries
Period

Liabilities
E2 Purchase building with cash + - 200 + + + 200 = + + Current
E3 Purchase inventory on account + + + 100 + = + + 100 + Accounts payable 100 0
Total current liabilities 100 0
Ending balances + + $800 + + $100 + + $200 = + + $100 + + $1,000
Non-current 0 0
Total liabilities 100 0
Stockholders' equity
Common stock 1,000 0
Total stockholders' equity 1,000 0
Total liabilities and stockholders' equity $1,100 $0

Balance Sheet immediately after E3


The figure on the next page illustrates how the balance sheet can be
created from the BSE matrix.

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Chapter 1: Introduction to Balance Sheets 33

ABC Company Balance Sheet


After first three events in first year of operations

Assets End Bal Beg Bal


Current
Cash $800 $0
Owners' Inventories 100 0
Assets = Liabilities + Total current assets 900 0
Equity
Non-current
+ C + Inven + PPE = + AP + CS Property, plant and equipment 200 0
Beginning balances + + $0 + + $0 + + $0 = + + $0 + + $0 Total non-current assets 200 0
E1 Issue stock for cash + + 1,000 + + = + + + 1,000
Total assets $1,100 $0
Entries
Period

E2 Purchase building with cash + - 200 + + + 200 = + +


Liabilities and Stockholders' Equity
E3 Purchase inventory on account + + + 100 + = + + 100 + Liabilities
Ending balances + + $800 + + $100 + + $200 = + + $100 + + $1,000 Current
Accounts payable 100 0
Total current liabilities 100 0
Non-current 0 0
Total liabilities 100 0
Stockholders' equity
Common stock 1,000 0
Total stockholders' equity 1,000 0
Total liabilities and stockholders' equity $1,100 $0

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34 Navigating Accounting

Exercise 1.02
The following events occurred at CreativeABCs during the first two days
of December, 2010:
E1: Nick Carlstedt starts a retail toy company, CreativeABCs Inc., on
December 1, 2010. On December 2, he contributes $10,000 and
a business plan to CreativeABCs in exchange for 100 shares of
common stock that has $1 par value. 500 shares are authorized.
Nick’s accountant tells him the business plan can’t be recognized on
CreativeABCs’ balance sheet.
E2: CreativeABCs purchases debt securities for $5,500 on December 2.
The company expects to hold the securities for 3-6 months and it
classifies them as available-for-sale.
E3: CreativeABCs buys inventories on account from TrustySupplier for
$4,000 on December 2.
Required

(a) Use the chart of accounts below to complete the BSE matrix on the
next page.
(b) Record a BSE mini matrix for each of the entries (E1-E3).
(c) Complete the December 2, 2010 balance sheet on the next page.
(d) Identify the line items in the balance sheet you completed for part (c)
that were affected by each entry. Do not include subtotals and totals
affected by the entry. For example, do not include total current assets.
The solution starts on page 83.

CreativeABC Company
Chart of Accounts
ASSETS
Current
C Cash
Inven Inventory
StInv Short-term investments
LIABILITIES
Current
AP Accounts payable
OWNERS' EQUITY
Permanent
CS Common stock (non-par)

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Chapter 1: Introduction to Balance Sheets 35

Owners'
Assets = Liabilities +
Equity

+ C + StInv + Inven = + AP + CS
December 1, 2010 + + $0 + + $0 + + $0 = + + $0 + + $0
E1 Issue stock + + + = + +

E2 Purchase debt securities + + + = + +

E3 Purchase inventory on account + + + = + +

December 2, 2010 + + + = + +

CreativeABC COMPANY
BALANCE SHEETS
After first three events in December, 2010
(In Thousands)
Assets 02-Dec-10 01-Dec-10
Current
Cash
Short-term investments
Inventories
Total current assets
Non-current
Total assets

Liabilities and Stockholders' Equity


Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Total stockholders' equity
Total liabilities and stockholders' equity

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36 Navigating Accounting

Judgments Behind the Numbers


Thus far, you have gained a more informed understanding of balance
sheets by working your way down a hierarchy from primary balance sheet
classes, to current and non-current assets and liabilities, to line items
within these categories, to accounts whose ending balances determined
the numbers, to entries that affected the accounts.
This is not the end of this hierarchy. Experts probe several levels deeper
and each level reveals a much richer interpretation of the numbers. Here,
we are going to briefly introduce some of these concepts to give you an
appreciation for how fascinating and challenging accounting can become.
You know that entries record financial measures of events and
circumstances. However, deciding when measures are reliable enough
to be recognized on balance sheets can require considerable judgment.
By judgment, we mean objective experts will come to different answers,
even when given the same measurement objective and equal access to
information about the business context.
Still, numbers that do make it on to balance sheets require varying
degrees of judgment and some require considerable judgment. These
numbers are often associated with situations where there is also a good
deal of business judgment and related risks.
This section introduces four types of decisions that require considerable
judgment and collectively determine whether, when, where, and how
events and circumstances affect assets, liabilities, and owners’ equities,
and, more generally, financial statements:
• Recognition decisions determine whether, where, and when
information about events and circumstances are recognized in
financial statements;
• Measurement decisions determine how related qualitative
information is quantified in financial terms;
• Classification decisions assign events or their financial measures
to categories that have different recognition and/or measurement
consequences. They can determine where an item is recognized
in a financial statement, when an item is recognized, or how it is
measured.
• Disclosure decisions determine whether these measures are visible
in accounting reports or footnotes or whether they are aggregated
with other information.
Before discussing these decisions, we will first describe the organizations
and individuals that make accounting decisions.

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Chapter 1: Introduction to Balance Sheets 37

Decision Making Hierarchy


To varying degrees of generality, accounting decisions requiring judgment
are made by a host of organizations and individuals in hierarchies that
stretch from the highest seats of government power to individual record
keepers.
Decisions at higher levels in these hierarchies guide or restrict those at
lower levels. In some situations, these restrictions and guidelines are so
strict that decision makers at lower levels have almost no leeway. In other
situations, they are more lax and considerable judgment is required to
apply them.
Decisions pertaining to financial statements issued in the United States
are made throughout legislative, judicial, and corporate hierarchies. The
legislative hierarchy has its pinnacle in Congress. However, Congress
delegates most of this responsibility to the Securities and Exchange
Commission (SEC), which in turn delegates most financial reporting
decisions to the Financial Accounting Standards Board (FASB).
The FASB is not a government agency. Rather, it is a private-sector body
that is composed of seven representatives from academicians, practicing
accountants, and users of financial reports. The FASB has issued more
than 150 pronouncements since it was founded in 1973. These are
referenced by numbers and are called Financial Accounting Standards
(FAS). Navigating Accounting will frequently cite and discuss these FASB
standards. It also will discuss the alternatives the FASB considered when
deciding on them and the factors that influenced the standard setting
process. These high-level accounting decisions have a profound effect on
corporations’ financial reporting decisions.
The FASB standards are part of a broader body of authoritative
pronouncements and practices called Generally Accepted Accounting
Principles, or GAAP for short. As its name suggests, GAAP encompasses
standards and practices that are widely accepted including, among other
things: (1) FASB Standards, (2) SEC pronouncements, (3) American
Institute of Certified Public Accountants (AICPA) pronouncements, and
(4) industry guidelines and norms.
While corporate financial reporting decisions are guided and restricted
by GAAP, some GAAP principles have more authority than others. For
example, FASB standards and SEC pronouncements have strong legal
authority, while norms and industry standards have less authority.
Here are key lessons about financial-reporting decision hierarchies:
• The legislative hierarchy starts with broad laws passed by
Congress, which restrict or guide more specific regulations
developed by the SEC and FASB, which further restrict

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38 Navigating Accounting

or guide rulings written by the AICPA and others who


determine GAAP, which restrict or guide policies established
by corporate boards of directors, chief executive officers,
and chief financial officers, which increasingly restrict or
guide procedures and decisions at various levels throughout
companies.
• Similarly, the judicial hierarchy starts at the U.S. Supreme
Court and extends through the legal system to boards of
directors, and then through the corporation via procedures
and policies.
• Thus, corporate financial reporting procedures and policies
are restricted and guided by decisions made by the legislative
and judicial branches of government.

Recognition Decisions
Recognition decisions determine whether events or circumstances affect
reports, and if so, where and when they affect them. More specifically,
they determine whether and when financial measures associated with
resources, claims on those resources, or events that change or give rise to
them should be mapped to specific report elements.
For example, if a company purchases a building, its cost is recognized as
an asset. In this example, the financial measure is the cost, the event is the
purchase, and the report element is an asset. Strictly speaking, we say the
cost of the purchase is recognized as an asset. More generally, we say that
a financial measure of an event is recognized as a specific report element,
with the understanding that an event is an occurrence that affects an
entity’s resources or claims on these resources.
However, in practice you might hear this accounting decision described
using almost any combination of these words: recognized, cost, purchase,
and asset. For instance: “we recognized the cost as an asset,” or “we
recognized the purchase as an asset,” or “we recognized an asset,” or,
simply, “we recognized the purchase on the balance sheet.” You will also
see reported used as a synonym for recognized. For example: “we reported
the building on the balance sheet.”
Recognition Criteria
Recognition decisions hinge on definitional criteria and measurement
criteria. With regards to balance sheets, a financial measure associated
with an event or circumstance meets the criteria to be recognized as an
asset, liability, or owners’ equity if it meets the elements’ definitional and
measurement criteria. The FASB has determined definitional criteria for

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Chapter 1: Introduction to Balance Sheets 39

the primary elements of balance sheets, income statements, and statements


of cash flows.
Defining report elements is a high-level accounting decision that is made
infrequently but has a tremendous impact on reporting. Loosely speaking,
the related definitional criteria determines the shape of the holes events
must fit through to be recognized. For example, a customer’s promise to
pay for goods or services meets the definitional criteria for an asset under
GAAP — the promise is a probable future economic benefit obtained or
controlled by a particular entity as a result of past transactions or events.
Keep in mind that the promise —the asset — is distinct
from its financial measure. Assets and liabilities are defined
qualitatively in terms of resources and obligations, or events
that create or change them. Financial measures quantify
these concepts.
A resource can meet the definitional criteria for an asset and still not be
recognized on balance sheets under GAAP. Assets, liabilities, and owners’
equities must also satisfy measurability criteria. According to the FASB,
an asset, liability, or owners’ equity meets the measurability criteria for
recognition if it has a relevant attribute that is measurable with sufficient
reliability on the report date.
For example, suppose a company and a customer have an informal
meeting during which the company promises verbally to deliver
considerable software at a future date and the customer promises to make a
payment thereafter. The customer’s promise meets the definitional criteria
for an asset (accounts receivable) but it does not meet the measurability
criteria: the consensus opinion of those in authority is that there does
not exist a financial measure of the receivable when the informal meeting
occurs that meets the measurability criteria for an asset.
This illustrates a subtle but important point. The customer’s promise is an
asset but it is not recognized on the balance sheet under GAAP when this
informal company-customer meeting occurs. Indeed, no report element is
recognized at this time even though a significant economic event occurred.
The value of the company’s common stock could rise significantly because
of the deal, but nothing would be recognized in its financial statements.
This is not an isolated situation.
Many business events are “off the books,” meaning no report
element is recognized in any of the financial statements when
the event occurs.
This decision not to recognize the customer’s and company’s promises
when the informal deal is struck would not be controversial. Most

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40 Navigating Accounting

accountants, regulators, managers, and users would agree that these early
informal promises cannot be measured reliably. There is too much risk
that the deal will not materialize as planned. The controversy heats up as
additional events occur that provide more reliable information.
Measurement Decisions
Measurement decisions determine how assets, liabilities, owners’ equities
and other financial-statement items are measured and also the best
measure or measurement procedure among those that meet the criteria
for recognition.
Measurement Attributes and Qualities
Recall that an item (event, resource, etc.) meets the measurability criteria
for recognition as a financial statement element if it has a relevant
attribute that is measurable with sufficient reliability.
Measurement attributes are qualitative features or dimensions of report
elements that can be measured. For example, the historical cost and
current market value of a building are distinct measurement attributes of
this asset. Each captures a feature of the building’s future benefit, and the
extent to which these attributes differ can vary considerably, depending
on the reporting context. Measurement attributes are also called
measurement objectives or measurement basis.
Asking accountants to measure the historical cost of a building is a
different measurement task from asking them to measure its current
value. Importantly, it is not just the measures that differ but also the
thing (attribute) being measured.
The historical cost of a depreciable asset such as a building, that
is an asset that is used-up over time, is the value of the item that was
exchanged for the asset when it was purchased, adjusted for depreciation
(usage) since the purchase date. This is sometimes called the adjusted
historical cost to differentiate it from the original cost.
If the building is purchased with cash, its historical cost at the time of the
purchase is measured precisely. If it is acquired in exchange for a patent,
estimating its historical cost at this time is considerably more challenging
(patents are unique resources that are difficult to value reliably).
Thereafter, measuring the historical cost adjusted for depreciation
(adjusted cost) requires assumptions about the expected pattern of
future usage. Generally, the usage patterns expected when buildings are
acquired are not changed thereafter for accounting purposes, and thus
the depreciation schedule is known when the building is purchased.

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Chapter 1: Introduction to Balance Sheets 41

In contrast, as its name suggests, the current value of an asset is based


on current information. Fair value is a specific type of current value. The
fair value of an asset is the expected price that an unrelated party would
be willing to pay for the asset today. Unrelated parties are more likely to
assess current values “fairly” than related parties because unrelated parties
are objective.
If the value of an asset appreciates, its fair value increases, but its historical
cost does not increase. Fair values are increasingly reported in footnotes in
companies’ annual reports, and, to a lesser degree, recognized in balance
sheets.
When the recognized value of an asset or liability is changed because of
the arrival of new information, we say that a valuation adjustment has
been made. The decision to recognize such valuation changes is often
extremely controversial.
We will study several ways to measure the current value attribute and thus
several ways to determine valuation adjustments. These include market
prices for items that are traded frequently, comparable-price assessments
for assets that are not traded frequently that are based on recent exchanges
of similar items (comparables), and present values of future cash flows
determined using formulas discussed in later chapters.
The qualities of accounting measures or the procedures that generate
them refers to the usefulness of these measures for decision making.
Relevance and reliability are two dimensions of usefulness. While the
FASB has rigorously defined relevance and reliability, we will simplify and
slightly modify their definitions for our purposes.
A measure is relevant to a user to the extent it is timely and its
measurement objective (typically the measurement attribute it aims to
measure) is pertinent to the user’s decisions. A measure is reliable to the
extent that it measures what it is intended to measure (its objective) and
the underlying measurement process can be validated by data or theory.
Measurement Alternatives
In principle, whenever possible the recognized measure of an item (event,
resources, etc.,) should be the one that is most useful for all user decisions.
In practice, it is often impossible to identify a measurement procedure or
guideline that meets this criterion.
For example, one measurement alternative might provide measures that
are more relevant to some users’ decisions and another might provide
measures that are more relevant to other users’ decisions. The comparisons
become even more complicated when the reliability of the measures from
alternative procedures differ, which is frequently true.

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42 Navigating Accounting

Because there is typically not a consensus as to what the best


measurement procedure is, GAAP often permits managers varying degrees
of leeway to choose a measurement procedure and to make assumptions
that are needed to implement this procedure.
Measurement decisions, like recognition decisions, are made throughout
reporting hierarchies. Higher-level decision makers decide whether
to impose broad measurement restrictions and guidelines or, more
specifically, to limit the permissible measurement procedures and related
assumptions at lower levels.
There is often considerable controversy concerning the measurement
alternatives that are, or are not, available to companies.
Measurement Controversies
Choosing the measurement attribute to recognize in accounting reports
usually involves a trade-off between relevance and reliability. The
relative presence or absence of these accounting qualities depends on the
reporting context.
For example, there is usually extensive debate as to whether assets or
liabilities should be recognized at their adjusted historical costs versus at
their current values. These debates center on trade-offs between relevance
and reliability. In particular, in most contexts there is agreement that
current values are more relevant because they reflect recent information
and that historical costs are more reliable because they are based on arms-
length transactions.
The debate hinges on trade-offs: recognizing the current value attribute
involves sacrificing reliability to gain relevance, while recognizing
historical costs requires sacrificing relevance to gain reliability. The
outcomes from these debates differ for various balance sheet items in the
same country and for the same item in different countries. This suggests
there are good arguments in favor of both alternatives for different
reporting environments.
For example, under U.S. GAAP, buildings are recognized as assets at their
adjusted historical cost unless their current market value is significantly
lower than this adjusted cost. Of note is the fact that if the value of a
building appreciates, the increase in value is not recognized under U.S.
GAAP. In contrast, in the United Kingdom companies have the option
under U.K. GAAP to recognize buildings at their adjusted historical cost
or estimated current market value (based on an assessment).

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Chapter 1: Introduction to Balance Sheets 43

Here are some key measurement lessons:


• Assets, liabilities, and owners’ equities are frequently
measured differently around the world.
• Some assets are recognized at their current values under
U.S. GAAP, others at their adjusted historical cost, and still
others using other relevant attributes.

Classification Decisions
Classification decisions assign events or their financial measures
to categories that have different recognition and/or measurement
consequences. Depending on the context, they can determine “where”
in an item is recognized in a financial statement, “when” an item is
recognized, or “how” it is measured.
Some classification decisions specify the category of report elements
or specific elements where financial measures are recognized (once the
decision has been made to recognize a measure in a report and a measure
has been chosen from the acceptable alternatives).
For example, when a company recognizes a receivable when making a
sale on account, management, guided by GAAP, must decide whether to
classify the receivable as a current or noncurrent asset on its balance sheet,
thus, determining where it will be recognized in the financial statements.
Classification decisions can also determine when an item is recognized.
For example, leases are classified as operating or capital leases. If a lease
is classified as a capital lease, an asset and liability equal to the value of
the future lease payments is recognized at the time the lease is signed. By
stark contrast, if the lease is classified as an operating lease, there are no
financial statement consequences at the time the lease is signed. In later
chapters, you will learn why the financial statements differ so dramatically
for these choices. You will also learn that Gap, like most retailers, would
report dramatically different balance sheets if it classified its store leases as
capital rather than operating leases.
Classification decisions can also affect the way items are measured. For
example, later in this chapter you will learn that investment securities are
classified into three categories depending on how the company intends to
use them. This subjective assessment has important financial-statement
consequences because investments in two of the three categories are
recognized at their fair values while investments in the third category are
generally recognized at their historical cost. To summarize:
Classification decisions, like recognition and measurement
decisions, can require considerable judgment and have
substantial financial-statement consequences. As a result,

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44 Navigating Accounting

regulators often restrict the leeway management has when


making these judgments.

Disclosure Decisions
Disclosure decisions can also require various degrees of judgment,
depending on whether they are mandated or voluntary. A financial
measure or other information is disclosed when it’s visible.
Importantly, financial measures can be recognized in financial statements
without being disclosed therein or elsewhere. Recognition without
disclosure occurs when two or more recognized measures are aggregated
and users cannot see the separate measures. To grasp the significance
of this distinction between recognition and disclosure, consider that
thousands of measures are recognized in balance sheets, but they are
aggregated into 20 or so disclosed items.
Sometimes disclosures are not required by GAAP but are still provided to
meet users’ demands for relevant supplementary information. Naturally
enough, these are called voluntary disclosures. Other disclosures are
mandated by GAAP.
We will use the term aggregation decision to refer to the specific
type of disclosure decision that determines how recognized measures
are combined in reports. Aggregation decisions can have profound
and conflicting consequences for users. They summarize and hide
information, which often benefits some users and frustrates others.
For example, if Intel disclosed every financial measure that it recorded
during a reporting period and subsequently recognized, its financial
statements would require thousands of pages, and it would reveal
significant proprietary information to its competitors. Competitors
would clearly benefit from this aggregation decision but at the current
shareholders’ expense.
Aggregation decisions also have implications for the way you learn to use
reports. For example, when examining a reported measure, you will need
to know how to make informed conjectures about the measures that are
“hidden” within the reported measure.
We will refer to this task as reverse engineering because you will be
trying to reverse the process that created (or engineered) the reported
number: you will conjecture the major events behind the reported
number and the way they were measured and recognized.
By now, you should recognize that reverse engineering is an essential
skill for interpreting reported numbers and assessing their usefulness.

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Chapter 1: Introduction to Balance Sheets 45

However, common sense suggests that you cannot reverse engineer a


process unless you first understand how it was engineered.
This simple premise has huge implications for the way you learn
accounting. It implies that you must learn a good deal about how
financial measures are recorded and subsequently aggregated in reports
before you can pick apart and disaggregate line items in financial
statements.

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46 Navigating Accounting

Exercise 1.03
Using Nike’s balance sheet on page 75 (Figure 1.02) and Intel’s balance
sheet on page 74 (Figure 1.01) answer the questions below.
Search Icon Check your solutions on page 86.
This exercise requires you (a) Which line item in the asset section of Nike’s balance sheet likely
to search for information.
recognizes the historical cost of Nike’s corporate headquarters?
(b) Which line item recognizes patents and trademarks Nike acquired
from other companies? What are the future benefits associated with
these patents?
(c) Which line item recognizes shoes that Nike had produced but not yet
sold on May 31, 2002?
(d) True or False: Nike discloses the recognized value of its goodwill, net
of amortization on its balance sheet.
(e) True or False: Nike’s customers owe Nike $1,807.1 at the end of
fiscal-year 2002 (May 31st).
(f ) True or False: The “net” in “Property, plant, and equipment, net”
indicates that property plant and equipment is reported net of its
accumulated depreciation.
(g) True or False: The cost of the inventories that Nike sold during fiscal
2002 was $50.3 million ($1,424.1-$1,373.8).
(h) Identify at least one asset that is recognized by both Nike and Intel;
however it is disclosed on Intel’s balance sheet, but not disclosed on
Nike’s balance sheet.
(i) Identify an asset that appears to be disclosed by both Intel and Nike,
but with slightly different labels (descriptions).

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Chapter 1: Introduction to Balance Sheets 47

Exercise 1.04
This question pertains to Federal Express’ balance sheet (Figure 1.03 on
the page 76). Check your answers on page 87.
(a) Assets are resources that are expected to provide future benefits and
Usage Icon are owned or controlled by the company because of past transactions
This exercise or events. Considering Federal Express’ business, briefly describe
helps you learn
how accounting the future benefits associated with the following assets recognized in
reports are used Federal Express’ balance sheet: (1) Cash and cash equivalents and (2)
by investors, Spare parts, supplies, and fuel.
creditors, and other
stakeholders. (b) The future benefits associated with assets are often risky to varying
degrees, meaning that their future benefits might not materialize or
might turn out to be worth less than anticipated when they were
acquired or produced. Describe events or circumstances that are
associated with the following assets’ riskiness: (1) Receivables; (2)
Aircraft and related equipment; and (3) Computer and electronic
equipment.
(c) Fair values must be estimated at the balance-sheet date and generally
the reliability of these estimates depends on the availability of prices
of recent sales of identical or similar assets. Thus, the fair values of
highly liquid assets that are traded frequently in markets that report
trade prices can be estimated very reliably. Assess the reliability of fair
value estimates for the following assets recognized by Federal Express:
(1) Cash and cash equivalents; (2) Aircraft and related equipment;
and (3) Package handling and ground support equipment and
vehicles.
(d) When an asset becomes impaired, it is written down to its fair value.
Describe events or circumstances that could cause Federal Express to
write down its receivables.
(e) In some countries, notably the United Kingdom, property, plant,
and equipment can be written up to its fair value when its fair value
exceeds its historical cost adjusted for depreciation. This is not
permitted under GAAP in the United States. What are the pros and
cons to allowing write-ups?
(f ) Intel and Nike recognize and disclose significant inventories on their
balance sheets (Figures 1.01 and 1.02). By contrast, Federal Express
does not disclose inventories on its balance sheet and probably does
not recognize them. What differences in these businesses explain this
accounting difference?

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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48 Navigating Accounting

Exercise 1.05
Answer the questions below using Nike’s and Federal Express’ balance
sheets (Figures 1.02-1.03 on pages 75 and 76, respectively).
Check your solutions on page 88.
Search Icon (a) Which line item in the liabilities section of Nike’s balance sheet likely
This exercise requires you recognizes Nike’s short-term obligations to banks?
to search for information.
(b) True or False: Federal Express’ total obligation related to Long-term
debt is $1,800 at the end of fiscal 2002.
(c) Estimate Nike’s total obligation related to long-term debt at the end
of fiscal 2002.
(d) True or False: Since Federal Express does not disclose an income taxes
liability on its balance sheet at the end of fiscal 2002, we can safely
conclude that Federal Express did not owe income taxes to one or
more governments at that date.
(e) What line item on Federal Express’ balance sheet and line items on
Intel’s balance sheet seem to closely resemble “Accrued liabilities” on
Nike’s balance sheet?
(f ) True or False: At the end of fiscal 2002, Federal Express owed its
employees $739 for services they had already provided to Federal
Express prior to that date.
(g) What are the total liabilities recognized by Nike and Federal Express
for the most recent year given? Which company had the most total
liabilities?
(h) Liabilities are claims on assets. Which company (Nike or Federal
Express) recognized the most liabilities as a percentage of total assets?
(i) Working capital is current assets less current liabilities. Which
company (Nike or Federal Express) had the most working capital?
(j) All financial measures can have strengths and weaknesses. What are
some weaknesses with the working capital measure? That is, what
are some reasons why the working capital recognized on the balance
sheet at year end might not be a good measure of a company’s ability
to pay its liabilities during the upcoming year?
(k) True or False: At the end of fiscal-year 2002, Federal Express owed a
total of $599 to governments that was associated with future income
tax forms.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 49

Exercise 1.06
R A =L +O E
E
ssets iabilities wners' quities

cash +other assets temporary OE


C
= liabilities + permanent OE+

O Beg Bal Zero

R E
n
D t
r
K i

Wil Carlstedt starts SimpleSales Inc. on January 1, 2008 by contributing


e
E s

E Tr Bal

P Cls IS
Cls RE
I

$1000 and a business plan to SimpleSales in exchange for 100 shares of


N End Bal Zero

G
Direct Cash Flows Balance Sheets Income Statements

common stock that has $1 par value. 500 shares are authorized.
Operating Assets Revenue

E Investing Liabilities Expenses

P Financing Owners' Equity Gains & Losses

O Cash change Net Income


R
T Reconciliations

A banker friend of Wil’s estimates that the business plan has a fair value
I Net Income
N Adjustments
G Operating Cash

of $4,000 on January 1, 2008. He also informs Wil that accountants will


Record keeping and probably not allow SimpleSales to recognize the business plan as an asset
Reporting Icon on its balance sheet because the business plan likely fails at least one of
This exercise requires the two asset-recognition criteria: to be recognized as an asset, an item
you to create balance
sheets, which are a type of must satisfy the definition of an asset (definitional criterion) and it must
accounting report. be measurable with sufficient reliability (measurability criterion).
Wil’s accountant informs him that determining whether an item meets
NOTE 2. SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES these criteria can require considerable judgement. He also tells him that
Principles of Consolidation
The accompanying consolidated financial statements include
the accounts and transactions of the Company together with
its wholly owned subsidiaries. All intercompany balances and
business plans definitely do not meet the asset-recognition criteria and
transactions have been eliminated in the consolidation.

Use of Estimates
The preparation of financial statements in conformity with
generally accepted accounting principles requires management
thus his business plan can not be recognized on SimpleSales’ balance
sheet.
to make estimates and assumptions that affect reported
amounts and related disclosures. Actual results could differ
from those estimates.

Judgment Icon
The solutions to the following questions and exercises are on page 91.
This exercise requires you (a) Create a balance sheet for SimpleSales at the end of January 1, 2008
to analyze an accounting that would be acceptable to regulators and standard setters using the
decision that requires
judgment. following format:

Consolidated Balance Sheet


1/1/2008
Assets
Current assets:
Cash and equivalents
Total current assets
Total assets

Liabilities and stockholders' equity


Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value
Total stockholders' equity
Total liabilities and stockholders' equity

(b) Explain why the business plan likely meets the definitional criterion
for asset recognition. To this end, recall that assets are resources that
are expected to provide future benefits and are owned or controlled by
the company because of past transactions or events.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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50 Navigating Accounting

(c) Explain why the business plan likely fails to meet the measurability
criterion for asset recognition.
(d) Suppose hypothetically that the accounting rules did permit the
business plan to be recognized using the banker’s $4,000 estimate.
Create a balance sheet for SimpleSales at the end of January 1, 2008
that includes the business plan using the line-items on Intel’s balance
sheet.
(e) Discuss the pros and cons of the balance sheets in (a) and (d) for
helping other potential investors determine SimpleSales’ financial
position at the end of January 1, 2008.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 51

R
E
C
O Beg Bal
A ssets

cash +other assets


=L
=
iabilities +O wners'

liabilities + permanent OE+


E

Zero
quities

temporary OE
Exercise 1.07
R E

This exercise extends Exercise 1.06 and, in particular, carries forward


n
D t
r
K i
e
E s

E Tr Bal

its assumptions. In addition, assume that on January 2, 2008


P Cls IS
Cls RE
I
N End Bal Zero

SimpleSales purchases stylish clothes from FancyFashions for $600 that


Direct Cash Flows Balance Sheets Income Statements

R Operating Assets Revenue

E Investing Liabilities Expenses

P Financing

SimpleSales intends to resell to its customers. SimpleSales promises to


Owners' Equity Gains & Losses

O Cash change Net Income


R
T Reconciliations
I Net Income

pay FancyFashions $600 for the merchandise within 30 days or pay an


N Adjustments
G Operating Cash

interest penalty thereafter.


Record keeping and FancyFashions has a secured interest in the merchandise and, in
Reporting Icon particular, can seize it from SimpleSales if the $600 plus accumulated
This exercise requires interest is not completely paid within three months from the purchase
you to create balance date. If the merchandise value declines to the point where it is not
sheets, which are a type of
accounting report.
sufficient to cover the amount owed to FancyFashions when it seizes the
merchandise, SimpleSales is obligated to pay the difference.
The solutions to the following questions and exercises are on page 93.
(a) Create a balance sheet for SimpleSales at the end of January 2, 2008
that would be acceptable to standard setters and regulators using the
format below and assuming that cash and the clothes purchased from
FancyFashions are the only recognized assets.

Consolidated Balance Sheet


1/2/2008
Assets
Current assets:
Cash and equivalents
Inventories
Total current assets
Total assets

Liabilities and stockholders' equity


Current liabilities:
Accounts payable
Total current liabilities

Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value
Total stockholders' equity
Total liabilities and stockholders' equity

(b) What are the book values of the creditor’s and owners’ claims on
January 2, 2008? What are the fair values of these claims assuming
that the business plan has a fair value of $4,000?

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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52 Navigating Accounting

For parts (c)-(d), suppose that on January 3, 2008 an article at a popular


fashion web site announced a new fashion line that will cause the retail
prices of the clothes that SimpleSales had purchased the day before to
drop immediately to $200. This was devastating news to Wil Carlstedt
because he had expected that SimpleSales would sell the clothes for
$2000.
(c) Assuming that the business plan still has a fair value of $4,000,
what are the book and fair values of the creditor’s and owner’s claim
immediately after the January 3rd fashion article is released?
(d) Create a balance sheet for January 3, 2008 that would be acceptable
to standard setters and regulators using the format below, assuming
that SimpleSales recognizes a $400 inventory impairment (write-
down) and a $400 loss that affects retained earnings. Ignore taxes.

Consolidated Balance Sheet


1/3/2008
Assets
Current assets:
Cash and equivalents
Inventories
Total current assets
Total assets

Liabilities and stockholders' equity


Current liabilities:
Accounts payable
Total current liabilities

Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 53

Exercise 1.08
R A =L +O E
E
ssets iabilities wners' quities

cash +other assets temporary OE


C
= liabilities + permanent OE+

O Beg Bal Zero

R E
n
D t
r
K i

This exercise extends Exercise 1.07 and, in particular, carries forwards


e
E s

E Tr Bal

P Cls IS
Cls RE
I
N End Bal

its assumptions. In addition, assume the following:


Zero

G
Direct Cash Flows Balance Sheets Income Statements

R Operating Assets Revenue

E Investing Liabilities Expenses

P Financing

• Contrary to parts (c) and (d) of Exercise 1.07, assume that ten
Owners' Equity Gains & Losses

O Cash change Net Income


R
T Reconciliations
I

minutes after the fashion story was posted on January 3, 2008,


Net Income
N Adjustments
G Operating Cash

Record keeping and the web site recanted its story and, as a result, SimpleSales made
Reporting Icon no adjustments to its balance sheet.
This exercise requires • January 4, 2008: SimpleSales purchases $500 of marketable
you to create balance
sheets, which are a type of securities with cash that it intends to liquidate in the future to
accounting report. cover an anticipated cash shortfall. The company anticipates
holding the securities for approximately six months.
• January 5, 2008: SimpleSales sells clothes to a customer for
$450 cash that it had purchased from FancyFashions for $150.
SimpleSales recognizes $300 of pretax income related to the
sale and $120 of income taxes, which it plans to pay to the
government in the near future. Thus, it recognizes $180 of net
income. (Unrealistically, we are assuming that there are no other
costs related to the sale except the $150 owed to FancyFashions
and the $120 owed to the government).
The solutions to the following questions and exercises are on page 94:
(a) Create a balance sheet for SimpleSales at the end of January 5,
2008 that would be acceptable to standard setters and regulators
using the format at the top of the next page, and assuming that
cash, clothes purchased from FancyFashions, and the marketable
securities purchased on January 4, 2008 are the only recognized
assets. Also assume that the market value of the securities is still
$500 at the end of January 5, 2008.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
54 Navigating Accounting

Consolidated Balance Sheet


1/6/2008
Assets
Current assets:
Cash and equivalents
Short-term investments
Inventories
Total current assets
Total assets

Liabilities and stockholders' equity


Current liabilities:
Accounts payable
Income taxes payable
Total current liabilities
Deferred tax liabilities
Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value
Accumulated other comprehensive income
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity

(b) What are the book values of the creditors’ and owners’ claims on
January 5, 2008? Assuming no other events occurred that affect fair
values and that the business plan still has a fair value of $4,000, what
are the fair values of these claims?
(c) How do the components of owners’ equity that are recognized on the
balance sheet (common stock and retained earnings) relate to events
that occurred since the business was started on January 1, 2008?
(d) Assume: (1) on January 6, 2008 the Wall Street Journal reported
that the market value of the securities purchased on January 4th had
increased from $500 to $600; (2) no other events occurred between
January 5th and 6th, (3) buying and selling marketable securities
is not part of SimpleSales primary business; and (4) SimpleSales
recognizes $40 of deferred taxes associated with the unrealized $100
pretax gain on the securities. Create a balance sheet for SimpleSales
at the end of January 6, 2008 that would be acceptable to standard
setters and regulators using the format at the top of the next page.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 55

Consolidated Balance Sheet


1/6/2008
Assets
Current assets:
Cash and equivalents
Short-term investments
Inventories
Total current assets
Total assets

Liabilities and stockholders' equity


Current liabilities:
Accounts payable
Income taxes payable
Total current liabilities
Deferred tax liabilities
Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value
Accumulated other comprehensive income
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity

(e) How do the components of owners’ equity that are recognized on the
balance sheet on January 6th relate to events that occurred since the
business was started on January 1, 2008?

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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56 Navigating Accounting

STATEMENT OF OWNERS’
EQUITY
To supplement balance sheets, companies also report statements of
owners’ equity, also called the statements of shareholders’ equity,
statements of stockholders’ equity, or statements of changes in owners’
equity. These statements explain changes in the owners’ equity line items
on balance sheets, usually for the past three years.
Figure 1.06 on page 79 presents the Statement of Stockholders’ Equity
reported in Intel’s 2007 Annual Report (page 50). The columns are items
reported in the Stockholders’ Equity section of Intel’s balance sheet:
Common stock and capital in excess of par value, Accumulated other
comprehensive income (loss), Retained earnings, and Total [Stockholders’
equity]. The rows are balances reported at year ends 2004-2007 and the
interim events that caused them to change.
To see how the statement of stockholders’ equity relates to the balance
sheet, focus on the rows near the bottom of the statement that begin with
“Balance at December 30, 2006” and end with “Balance at December 29,
2007.” (Intel’s fiscal yearend is the last Saturday in December.)
Notice that the numbers reported in these rows correspond to those
reported on the balance sheet. For example, Intel’s balance sheet
recognized $30,848 and $28,98 of retained earnings at year-ends 2007
and 2006, respectively. These amounts are also reported in the Retained
earnings column of the Statement of Stockholders’ Equity: the rows
named Balance at December 30, 2006 and Balance at December 29 2007,
respectively.
The statement of stockholders’ equity describes the reasons why the
balances reported on balance sheets changed during reporting periods.
For example, the bottom section of Intel’s statement explains the reasons
why retained earnings increased $1,864 during 2007 (from $28,984 at
the end of 2006 to $30,848 at the end of 2007). To understand how the
statement explains these changes, first notice that five numbers in the
Retained earnings column explain the increase: ($181), $181, $6,976,
($2,494) and ($2,618).
Connecting these numbers to the descriptions on the left side of the
corresponding rows, we see the five events that caused the change in Intel’s
retained earnings. The changes in most companies’ retained earnings
during a reporting period can be explained by two events: net income and
dividends.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 57

More generally, as you progress through Navigating Accounting, you will


gradually learn how to interpret the events on statements of owners’
equities. For now, the important observations are:
(1) Eventually, you will need to understand how to interpret these events
to understand the changes in related balance-sheet items.
(2) Like balance sheets, statements of shareholders’ equity reports
balances at points in time. But they also explain the reasons why these
balances change during reporting periods.
(3) Most statements of shareholders’ equity are similar to Intel’s
statement: the columns correspond to line items reported in the
owners’ equity section of balance sheets and the rows are either
year-end balances or the events that caused these balances to change.
However, at least one major company reverses the rows and columns:
Microsoft reports the balance sheet items in the rows and the balances
and events in the columns.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
58 Navigating Accounting

HOW DO I USE THE NUMBERS?


We started this chapter stating that the purpose of a balance sheet is to
help financial statement users assess a company’s financial position at a
point in time. Now that you know more about balance sheets and what’s
behind them, let’s return to Intel and see how you can use balance sheets
to assess Intel’s financial position at the end of 2007. So, how healthy is
Intel’s financial condition?
First, we analyze Intel’s assets to assess whether its resources are sufficient
to meet its obligations, especially if there’s a downturn in the economy.
Here, we find Intel is in great shape. It had over $55 billion in total
assets versus around $13 billion in total liabilities at the end of 2007.
Surprisingly, Intel has relatively little debt for a large, global company.
Thus, Intel does not rely on external financing.
One implication of creditors having priority at liquidation is that their
risk of loss (credit risk) decreases when shareholders have a larger stake in
the business. Holding asset risk constant, the higher the ratio of owners’
equity to liabilities, the more creditors are inclined to contribute resources
Alternative Ways to under favorable conditions (lower interest rates, etc.).
Compute Leverage
Financial leverage is the extent to which shareholders’ claims are risky
Financial leverage can
be measured as: because of liabilities. It measures the extent to which a company’s assets
are financed with debt rather than equity.
• Liabilities divided
by assets
Financial Leverage Ratio
• Assets divided by
owners’ equity Financial Total Total
Leverage
= Liabilities / Assets
• Liabilities divided
by owners’ equity,
which is also called The higher the financial leverage, holding asset risk constant, the higher
debt-to-equity ratio
the return shareholders will demand to compensate for the additional
The leverage numbers
differ for the formulas,
risk. Owners’ claims become riskier when financial leverage increases
but the conclusions will because creditors must be paid the same amount regardless of how well
be the same. the company performs. In good (bad) times, owners will earn higher
(lower) returns if financial leverage increases.
Intel’s leverage is particularly low, at 23%, versus its biggest competitor,
Advanced Micro Devices, (AMD) at 74% at the end of 2007.
Next, we need to look deeper into Intel’s balance sheet and, in particular,
at its liquidity risk — the risk the company’s liquid assets will not be
adequate enough to meet its near-term obligations. Here we notice Intel’s
current assets are almost three times as large as its current liabilities,

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 59

further indicating that Intel as a cushion to weather a downturn. This


excess of current assets less current liabilities is called working capital.

Working Capital

Working Current Current


Capital
= Assets - Liabilities

As working capital decreases, the risk that the company will not meet its
obligations, or will forego new opportunities unless it secures additional
external financing, increases.
In general, it is not appropriate to compare working capital amounts
across companies because larger companies need more than smaller ones.
Analysts compensate for this by computing the company’s current ratio
to measure the current assets per dollar of current liabilities.

Current Ratio

Current = Current Current


Ratio Assets / Liabilities

Intel’s current ratio (at nearly 3) is very favorable and nearly twice as large
compared to its competitor AMD.
Now, we are ready to look at the third level of our analysis of Intel’s
balance sheet: line items. By looking at specific line items on Intel’s
balance sheet we are able to connect Intel’s financial condition to the
underlying business context.
For example, Intel has over $15 billion in liquid assets. We can connect
this to Intel’s business: Intel needs significant cash for research and
development for inventing new microprocessor chips and for building
new, expensive manufacturing facilities to produce these chips. Because
it takes years to invent new cutting-edge technology and 3 – 4 years
to construct the specialized facilities, Intel must have significant cash
to support these activities long before it starts to sell the new chips to
customers.
These high-level analyses lay the foundation for the importance of
knowing what’s behind the numbers and relating this knowledge to the
business and the environment in which a company competes. Taken
together, this will help you better interpret a company’s balance sheet and
other financial information.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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60 Navigating Accounting

So, how healthy is Intel’s financial condition? Overall, Intel had a very
strong financial position at the end of 2007. It had significant liquid
assets and minimized shareholder risk through low financial leverage.
Intel has positioned itself well to remain at the forefront of new
technologies and weather any slowdown in the economy.
Intel’s balance sheet reflects the growth in the company over the last four
decades since it was founded in 1968. Indeed, Intel’s 2007 balance sheet
tells us a lot more about the company than its first balance sheet as a start-
up with an initial stockholder investment of only $10 thousand and debt
of $2.5 million.
However, Intel’s biggest assets are not on its balance sheet — its talented
employees and innovative ideas. These off-balance sheet resources are
critical to Intel’s future.

PREPARERS’ AND USERS’


PERSPECTIVES OF R&R MAP
The figure on the next page summarizes many of the concepts discussed
in this chapter. In the process, it illustrates how the R&R Map can help
you understand how balance sheets and other financial statements can be
prepared and analyzed.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Owners'
Assets = Liabilities +
Insiders’ perspective Equity

Current + Non-current = Current + Non-current + Permanent


Outsiders’ perspective
+ C + AR + Inven + OCA + PPE + ONCA = + AP + OCL + LTD + ONCL + SCap + OPOE
• Observes events December 31, 2012 + + $13 + + $78 + + $103 + + $178 + + $175 + + $199 = + + $35 + + $95 + + $60 + + $70 + + $214 + + $272 • Observe and analyze primary elements
E1 Issued share capital for cash + + 10 + + + + + = + + + + + + 10 +

E2 Issued non-current debt for cash + + 10 + + + + + = + + + + 10 + + +


• Makes recognition decisions E3 Purchased PP&E with cash + - 20 + + + + + 20 + = + + + + + +

E4 Purchased merchandise for resale + + + + 80 + + + = + + 80 + + + + + • Observe and analyze major categories


E5 Paid invoices due + - 225 + + + + + = + - 225 + + + + +

Period Entries
• Makes measurement decisions Other period entries + + 243 + + 28 + - 36 + + $51 + -1 + + 34 = + + 135 + + $2 + + 35 + + 30 + + 29 + - 25
December 31, 2013 + + $31 + + $106 + + $147 + + $229 + + $194 + + $233 = + + $25 + + $97 + + $105 + + $100 + + $253 + + $360
• Observe and analyze line items
• Records entries
BISCHOFF GLOBAL SPORTSWEAR • Envision accounts behind line items
• Determines ending balances STATEMENTS OF FINANCIAL POSITION

December 31, 2013 and December 31, 2012

(In Millions)
• Makes disclosure decisions Assets 2013 2012
• Envision structure of related entries
Current
Cash and cash equivalents $31 $13
Accounts receivable, net 106 78
• Creates balance sheets Inventories 147 103 • Identify other line items and footnotes
Other current assets 229 178
Total current assets 513 372
Non-current
Property, plant, and equipment, net 194 175
Other non-current assets 233 199
Total non-current assets 427 374
affected by entries and search for related
Total assets $940 $746

Liabilities and Stockholders' Equity information


Liabilities
Current
Accounts payable 25 35
Other current liabilities 97 95
Total current liabilities 122 130 • Qualitatively gauge measures
Non-current
Long-term borrowings 105 60
Other non-current liabilities 100 70
Total non-current liabilities 205 130
Total liabilities 327 260

Stockholders' equity
• When possible, recreate entries and
Share capital 253 214
Other stockholders' equity 360 272
Total stockholders' equity 613 486
Total liabilities and stockholders' equity $940 $746
determine their ratio effects
• Envision measurement and recognition
judgments behind reported numbers and
assess confidence in them
Chapter 1: Introduction to Balance Sheets 61

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
62 Navigating Accounting

Exercise 1.09
Figures 1.04 and 1.05 on pages 77 and 78 reports common-size balance
sheets for Intel and the Gap.
Common-size balance sheets are created by dividing each balance
Usage Icon sheet measure by the recognized total assets at the balance-sheet date. As
This exercise suggested by the name, common-size balance sheets allow comparisons of
helps you learn companies of different sizes. They also facilitate comparisons across years
how accounting
reports are used for a company that is growing or shrinking.
by investors,
Answer the following questions using Figures 1.04 and 1.05. The
creditors, and other
stakeholders. solutions are on page 96.
(a) Common-size statements provide a way to calibrate the relative
importance of balance sheet items. Identify the four most significant
balance-sheet items for each company at the end of the most current
year.
(b) What do the common-size statements tell you about the two
companies’ asset composition and financial leverage measured as
liabilities divided by assets (L/A)?

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 63

Exercise 1.10
Answer the questions below using Nike’s and Disney’s statements
of shareholders’ equities (Figures 1.07-1.08 on pages 80 and 81,
respectively).
Search Icon Check your solutions on page 97.
This exercise requires you (a) How much net income did the companies each recognize during
to search for information.
fiscal 2002?
(b) How much common stock dividends did the companies each
recognize during fiscal 2002?
(c) Cash dividends are declared by the board of directors before they are
paid to shareholders. When a dividend is declared, retained earnings
decreases and a liability (dividends payable) increases. Combining
Usage Icon these two events, we see that ultimately cash dividends reduce cash
This exercise and retained earnings. Why does it make sense for retained earnings
helps you learn
how accounting
and thus the book value of the owners’ claims to decrease when a
reports are used dividend is declared and paid?
by investors,
creditors, and other (d) How many shares were issued to employees at Nike and Disney
stakeholders. during fiscal 2002 because employees exercised options?
(e) Identify two common items that explain changes in both companies’
retained earnings during fiscal 2002.
(f ) True or False: Nike recognized ($192.4) accumulated other
comprehensive income during fiscal 2002.
(g) True or False: Nike recognized $623.0 of comprehensive income
during fiscal 2002, which was comprised of $663.3 net income plus
$(40.3) of other comprehensive income.
(h) True or False: Disney recognized a net loss of $158 from its primary
businesses during fiscal 2001.
(i) True or False: Disney recognized a common stock dividend in 2000,
2001, and 2002.
(j) True or False: Disney recognized $38 and ($95) of other
comprehensive income during 2001 and 2002, respectively.
(k) Comprehensive income has two components: net income and other
comprehensive income. Why do you believe that investors want to
know these two components (rather than just their sum)?

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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64 Navigating Accounting

R
E
C
O
R
Beg Bal
E
A ssets

cash +other assets


=L
=
iabilities +O wners'

liabilities + permanent OE+


E

Zero
quities

temporary OE
Exercise 1.11
n
D t

No solution is provided for this question.


r
K i
e
E s

E Tr Bal

P Cls IS
Cls RE
I
N End Bal Zero

G
Direct Cash Flows Balance Sheets Income Statements Caveat: This exercise asks you to create several balance sheets. You are
R Operating Assets Revenue

E
P
O
R
Investing

Financing

Cash change
Liabilities

Owners' Equity
Expenses

Gains & Losses

Net Income
to do so without recording the entries that gave rise to the balance
sheets. That is, you are NOT to follow the process discussed earlier
T Reconciliations
I Net Income
N Adjustments
G Operating Cash

for Bischoff, ABC Company, and CreativeABCs company. That


Record keeping and process works here, but some of the entries are beyond the scope
Reporting Icon
of this chapter. Instead, here you are to simply value the assets,
This exercise requires
you to create balance
liabilities, and owners’ equity claims at each date and create a balance
sheets, which are a type of sheet from these values.
accounting report.
Part (a)
Assumptions

On 01/01/2008
• ABC Company is formed and issues common stock to two
shareholders in exchange for cash: $200 worth of stock to shareholder
A and $800 to shareholder B.
Usage Icon
• ABC creates a balance sheet immediately after issuing these shares.
This exercise
helps you learn On 01/02/2008
how accounting
reports are used • ABC acquires land that is next to a proposed mall for $1,000.
by investors,
creditors, and other • ABC creates another balance sheet immediately thereafter.
stakeholders.
On 12/28/2008
• ABC learns whether the mall has been approved.
On 12/30/2008
• ABC sells the land either for $2,000 if the mall is approved or for
$500 if the mall is not approved.
• ABC creates a final balance sheet immediately after selling the land
that recognizes the profit or loss it received from selling the land.
ABC is located in a country where there are no taxes.
On 12/31/2008
• ABC distributes all of its cash to its shareholders.
Required
Complete the balance sheets at the top of the next page for ABC (for the
indicated dates and circumstances) and determine shareholders’ gain or
loss on this investment under the two mall-approval scenarios.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 65

Consolidated Balance Sheet


12/31/2008, Pre Payoffs 1/2/2008 1/1/2008

Mall Mall not After land After


approved approved purchased financing
Assets
Cash and equivalents
PP&E
Total assets

Liabilities and stockholders' equity


Debt
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity

Total liabilities and stockholders' equity

SHAREHOLDERS
A B
Mall Mall Mall Mall
Approv Not Approv Approv Not Approv

Part (a)
Investment
Payoff
Gain/Loss

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
66 Navigating Accounting

Part (b)
Assumptions

The assumptions are the same as part (a) except:


• On 01/01/2008 ABC Company issues $200 of common stock to
shareholder A and $800 of debt to First Bank (there is no shareholder
B in this part). The bank expects to be repaid $800 of principal and
one year’s interest at 10% per year on 12/31/2008.
• On 12/31/2008, ABC creates a final balance sheet immediately after
selling the land that recognizes: (i) profit or loss ABC received from
selling the land, (ii) interest, if any, that ABC plans to pay First Bank
the next day (if it has enough cash to first pay off debt principal
and then pay owed interest) and (iii) gain, if any, associated with
decreasing the value of debt that ABC expects to repay (in the event
that it does not expect to have enough cash the next day to repay
debt principal.)
Required
Complete the balance sheets at the top of the next page for ABC (for the
indicated dates and circumstances) and determine shareholder A’s gain or
loss on this investment under the two mall-approval scenarios. Why have
Shareholder A’s gains or losses changed from part (a)? Has ABC’s asset
risk changed?

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 67

Consolidated Balance Sheet


12/31/2008, Pre Payoffs 1/2/2008 1/1/2008
After
Mall Mall not After
land
approved approved financing
purchased
Assets
Cash and equivalents
PP&E
Total assets

Liabilities and stockholders' equity


Debt
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity

Total liabilities and stockholders' equity

BANKS SHAREHOLDERS
First A
Mall Mall Mall Mall
Approv Not Approv Approv Not Approv

Part (b)
Investment
Payoff
Gain/Loss

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
68 Navigating Accounting

Part (c)
Assumptions

The assumptions are the same as part (b) except:


• On 01/01/2008 ABC Company issues $200 of common stock to
shareholder A, $800 of debt to First Bank, and $1,000 of debt to
Second Bank. First Bank expects to be repaid $800 of principal and
one year’s interest at 10% per year on 12/31/2008. Second Banks’
debt is subordinate to First Bank’s debt, meaning that First Bank is
paid first in the event there is not enough cash to pay both banks.
Second Bank expects to be repaid $1,000 of principal and one year’s
interest at 15% per year on 12/31/2008.
• ABC acquires two land parcels (rather than one) next to the proposed
mall that are identical to the one purchased in part (a) in all respects.
• On 12/31/2008, ABC creates a final balance sheet immediately after
selling both land parcels that recognizes profit or loss (following the
guidelines discussed in part (b)).
Required
Complete the balance sheets at the top of the next page for ABC (for the
indicated dates and circumstances) and determine shareholder A’s gain or
loss on this investment under the two mall-approval scenarios. Why does
the debt issued to Second Bank have a higher interest rate?

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 69

Consolidated Balance Sheet


12/31/2008, Pre Payoffs 1/2/2008 1/1/2008
After
Mall Mall not After
land
approved approved financing
purchased
Assets
Cash and equivalents
PP&E
Total assets

Liabilities and stockholders' equity


Debt
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity

Total liabilities and stockholders' equity

BANKS SHAREHOLDERS
First Second A
Mall Mall Mall Mall Mall Mall
Approv Not Approv Approv Not Approv Approv Not Approv

Part (c)
Investment
Payoff
Gain/Loss

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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70 Navigating Accounting

KEY TAKE-AWAYS
• The purpose of a balance sheet is to help users of financial statements
assess a company’s financial position at a reporting date.
• Financial position is characterized by financial measures of the
company’s assets and the claims on these assets taken on a reporting
date. There are two types of claims: (1) liabilities measure creditors’
claims on the assets, and (2) owners’ equities measure owners’ claims.
• The balance-sheet equation illustrates that the financial measures of
the assets and claims must always be equal:
Assets (A) = Liabilities (L) + Owners’ Equities (OE)
• Assets are resources that are expected to provide future benefits
and they are owned or controlled by the company because of past
transactions or events.
• Liabilities are obligations that companies incur when they do
something today, or discover that they did something in the past,
that indicates that they will likely be required to give goods or
services to other parties in the future.
• Owners have residual claims on a company’s assets, meaning
creditors are paid first in the event the company goes out of business
or files for bankruptcy.
• Companies, guided by GAAP, determine whether the definitional
and measurement criteria for recognizing assets, liabilities, and
owners’ equities are met and how these items are measured. GAAP is
determined by laws, regulations, and industry norms.
• Standard setters who determine GAAP and companies that apply it
often make complex decisions that require considerable judgment.
• Companies often describe the ways assets, liabilities, and owners’
equities are measured in their accounting policies footnotes, which
are typically found immediately after financial statements in annual
reports.
• Analyzing a company’s assets can help users of financial statements
assess whether the company’s resource-mix is appropriate to meet its
performance goals, especially when there are changes in economic
conditions. It can also help users assess the company’s asset risk
— the risk that the value of its assets will decline under various
assumptions about future economic conditions.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 71

• Analyzing the composition of a company’s equities can help users


determine the company’s financing risks. Financing risks differ from
asset risks in that asset risk reflects the riskiness of the asset side of
the balance sheet and financing risk depends on the composition
of the equities side. Financial leverage measures the extent to which
shareholders’ claims are risky because of liabilities.
• Synonyms often describe similar balance sheet concepts. With
practice, you will learn how to determine whether items are synonyms
from their context.
• Many financial measures of assets, liabilities, and owners’ equities
are recognized on balance sheets without being disclosed: they are
aggregated with other recognized measures. A measure is recognized
when it affects the balance sheet and disclosed when it is visible.
• Deciding whether recognized measures are disclosed or aggregated
can have profound and conflicting consequences for users of financial
statements. Aggregations summarize and hide information, which
often benefit some users and frustrates others.
• Netting is a special type of aggregation where positive and negative
effects are combined. There are different types of netting and, as a
result, “net” must be interpreted in context.
• The book values of assets, liabilities, and owners’ equities are the
amounts recognized on balance sheets. Book values often differ
significantly from fair values, which are the amounts that an unrelated
party would be expected to pay.
• Net income measures the company’s performance for a reporting
period for activities that are considered its primary business. In
contrast to net income, other comprehensive income is income
that does not pertain to a company’s primary business. Other
comprehensive income generally depends on changes in economic
factors that the company does not influence such as changes
in interest rates, currency exchange rates, and stock prices.
Comprehensive income is the sum of net income and other
comprehensive income.
• Three components of owners’ equity are commonly disclosed on
balance sheets: common stock, retained earnings, and accumulated
other comprehensive income. Retained earnings is the cumulative
net income the company has recognized since it was started, less the
cumulative dividends it has declared, plus or minus adjustments for
other events such as stock repurchases that occur less frequently.

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72 Navigating Accounting

• Balance sheets are often described as financial pictures of companies


at points in time. The discussion in this chapter and lessons from the
Enron fallout suggest that none of these pictures perfectly capture
financial reality and some in fact distort it considerably. Many
resources and obligations are not recognized on balance sheets as
assets and liabilities and those that are recognized are often reported at
values that are controversial:
(a) Valuable resources such as patents that meet the definitional
criterion for an asset are frequently not recognized on balance
sheets because these resources can not be measured reliably in the
collective opinion of those who determine GAAP.
(b) Recognizing fair values is not permitted for most assets because
measuring them can be very challenging, especially when market
prices are not available.
(c) Most assets recognized on the balance sheet are reported at
historical costs adjusted for usage, which can severely understate
or overstate their fair values.
(d) Significant obligations are often not recognized under
GAAP because they can not measured reliably or fail to meet
definitional criteria.
More generally, throughout Navigating Accounting, you will learn about
accounting decisions where considerable judgment is needed and where
errors in judgment can have dramatic financial statement consequences.
When making these decisions, honest errors are frequently made because
of the uncertain nature of measuring business activities. However, these
errors are usually relatively insignificant when compared to the value of
the company. Unfortunately, as we learned from the financial reporting
scandals that were front-page news during 2002, some disreputable
managers have viewed these decisions as opportunities to completely
distort reality by manipulating reported numbers and they have acted on
these opportunities to advance their self interests.
Hopefully, reforms and public pressure will significantly mitigate the
extreme opportunistic behavior that occurred at Enron, Global Crossing,
Waste Management, Sunbeam, Xerox, and Worldcom. But accounting
manipulations will likely continue to be a significant problem, albeit to
a lesser degree. For this reason, you should maintain a high degree of
skepticism when analyzing accounting numbers.
But skepticism is not the same as cynicisms. Skepticism vigorously
challenges the assumptions, theories, and facts that substantiate or

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 73

refute all hypotheses related to an issue, yet begins with an open mind.
By contrast, cynicism assumes the worst about human behavior and
vigorously seeks data that confirms these beliefs.
For example, a cynic assumes a company is necessarily manipulating its
income if its accounting policies, while consistent with GAAP, deviate
from industry norms and, as a result, increase its income relative to what
would be reported by conforming to industry practices. By contrast, a
skeptic tests this manipulation hypothesis as diligently as a cynic, but
also meticulously assesses whether the company’s accounting is a more
appropriate way to measure its business, assuming its business practices
differ significantly from those of its competitors.
To become a good skeptic, you will need to master: (1) what financial-
statement numbers are supposed to measure, and (2) how reliably they
meet these measurement objectives. Chapters 1-3 will help you begin
to address the first learning challenge by describing financial-statement
items and many of the related concepts. The remainder of Navigating
Accounting will help you learn how to assess the reliability of reported
numbers. To this end, you will learn how to determine the events,
circumstances, business decisions, and accounting decisions that underlie
accounting numbers and the factors that influence these decisions.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
74 Navigating Accounting

e10vk Page 66 of 134

Figure 1.01 Intel’s Balance Sheet


This figure illustrates Intel’s year-end balance sheets.
Table of Contents

INTEL CORPORATION
CONSOLIDATED BALANCE SHEETS

December 29, 2007 and December 30, 2006


(In Millions, Except Par Value) 2007 2006
Assets
Current assets:
Cash and cash equivalents $ 7,307 $ 6,598
Short-term investments 5,490 2,270
Trading assets 2,566 1,134
Accounts receivable, net of allowance for doubtful accounts of $27 ($32 in 2006) 2,576 2,709
Inventories 3,370 4,314
Deferred tax assets 1,186 997
Other current assets 1,390 258
Total current assets 23,885 18,280
Property, plant and equipment, net 16,918 17,602
Marketable equity securities 987 398
Other long-term investments 4,398 4,023
Goodwill 3,916 3,861
Other long-term assets 5,547 4,204
Total assets $55,651 $48,368

Liabilities and stockholders’ equity


Current liabilities:
Short-term debt $ 142 $ 180
Accounts payable 2,361 2,256
Accrued compensation and benefits 2,417 1,644
Accrued advertising 749 846
Deferred income on shipments to distributors 625 599
Other accrued liabilities 1,938 1,192
Income taxes payable 339 1,797
Total current liabilities 8,571 8,514
Long-term income taxes payable 785 —
Deferred tax liabilities 411 265
Long-term debt 1,980 1,848
Other long-term liabilities 1,142 989
Commitments and contingencies (Notes 20 and 21)
Stockholders’ equity:
Preferred stock, $0.001 par value, 50 shares authorized; none issued — —
Common stock, $0.001 par value, 10,000 shares authorized; 5,818 issued and outstanding (5,766 in
2006) and capital in excess of par value 11,653 7,825
Accumulated other comprehensive income (loss) 261 (57)
Retained earnings 30,848 28,984
Total stockholders’ equity 42,762 36,752
Total liabilities and stockholders’ equity $55,651 $48,368

See accompanying notes. Page 48, Intel’s 2007 10-K Annual Report
The company’s notes found in its annual report are an integral part of this statement.

48

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 75

Figure 1.02 Nike’s Balance Sheet


This figure illustrates Nike’s year-end balance sheets.

The company’s notes found in its annual report are an integral part of this statement.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
76 Navigating Accounting

fedex annual report 2002 LEADING THE WAY

Figure 1.03 Federal Express’ Balance Sheet


This figure illustrates Federal Express’ year-end balance sheets.

Consolidated Balance Sheets

May 31
In millions, except share data 2002 2001
ASSETS
Current Assets
Cash and cash equivalents $ 331 $ 121
Receivables, less allowances of $147 and $137 2,491 2,506
Spare parts, supplies and fuel, less allowances of $91 and $78 251 269
Deferred income taxes 469 488
Prepaid expenses and other 123 117
Total current assets 3,665 3,501
Property and Equipment, at Cost
Aircraft and related equipment 5,843 5,313
Package handling and ground support equipment and vehicles 4,866 4,621
Computer and electronic equipment 2,816 2,637
Other 4,051 3,841
17,576 16,412
Less accumulated depreciation and amortization 9,274 8,312
Net property and equipment 8,302 8,100
Other Assets
Goodwill 1,063 1,052
Other assets 782 739
Total other assets 1,845 1,791
$13,812 $13,392
LIABILITIES AND STOCKHOLDERS’ INVESTMENT
Current Liabilities
Current portion of long-term debt $ 6 $ 221
Accrued salaries and employee benefits 739 700
Accounts payable 1,133 1,256
Accrued expenses 1,064 1,073
Total current liabilities 2,942 3,250
Long-Term Debt, Less Current Portion 1,800 1,900
Deferred Income Taxes 599 508
Other Liabilities 1,926 1,834
Commitments and Contingencies
Common Stockholders’ Investment
Common stock, $.10 par value; 800,000,000 shares authorized; 298,573,387 shares issued for 2002 and 2001 30 30
Additional paid-in capital 1,144 1,120
Retained earnings 5,465 4,880
Accumulated other comprehensive income (53) (56)
6,586 5,974
Less treasury stock, at cost and deferred compensation 41 74
Total common stockholders’ investment 6,545 5,900
$13,812 $13,392

The accompanying notes are an integral part of these consolidated financial statements.

The company’s notes found in its annual report are an integral part of this statement.

29
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson ––
Chapter 1: Introduction to Balance Sheets 77

Figure 1.04 Intel’s Common Size Balance Sheets


This figure Illustrates Intel’s common size balance sheets. Common size balance sheets are derived by dividing
each balance-sheet number by total assets.

Intel Consolidated Balance Sheets


December 29, 2007 and December 30, 2006
(In Millions--Except Par Value) 2007 2006
Assets
Current assets:
Cash and cash equivalents 13.1% 13.6%
Short-term investments 9.9% 4.7%
Trading assets 4.6% 2.3%
Accounts receivable, net of allowance for doubtful accounts of $27 ($32 in 2006) 4.6% 5.6%
Inventories 6.1% 8.9%
Deferred tax assets 2.1% 2.1%
Other current assets 2.5% 0.5%
Total current assets 42.9% 37.8%
Property, plant and equipment, net 30.4% 36.4%
Marketable strategic equity securities 1.8% 0.8%
Other long-term investments 7.9% 8.3%
Goodwill 7.0% 8.0%
Other long-term assets 10.0% 8.7%
Total assets 100.0% 100.0%
Liabilities and stockholders' equity
Current liabilities:
Short-term debt 0.3% 0.4%
Accounts payable 4.2% 4.7%
Accrued compensation and benefits 4.3% 3.4%
Accrued advertising 1.3% 1.7%
Deferred income on shipments to distributors 1.1% 1.2%
Other accrued liabilities 3.5% 2.5%
Income taxes payable 0.6% 3.7%
Total current liabilities 15.4% 17.6%
Long-term income taxes payable 1.4% -
Deferred tax liabilities 0.7% 0.5%
Long-term debt 3.6% 3.8%
Other long-term liabilities 2.1% 2.0%
Commitments and contingencies (Notes 20 and 21)
Stockholders' equity:
Preferred stock, $0.001 par value, 50 shares authorized; none issued
Common stock, $0.001 par value, 10,000 shares authorized; 5,818
issued and outstanding (5,766 in 2006) and capital in excess of par value 20.9% 16.2%
Accumulated other comprehensive income 0.5% -0.1%
Retained earnings 55.4% 59.9%
Total stockholders' equity 76.8% 76.0%
Total liabilities and stockholders' equity 100.0% 100.0%
See notes to Consolidated Financial Statements.

The company’s notes found in its annual report are an integral part of this statement.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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78 Navigating Accounting

Figure 1.05 Gap’s Common Size Balance Sheets


This figure Illustrates Gap’s common size balance sheets. Common size balance sheets are derived by dividing
each balance-sheet number by total assets.

GAP's Common Size Consolidated Balance Sheets

($000 -except par value) Feb. 1, 2003 Feb. 2, 2002


Assets
Current Assets:
Cash and cash equivalents 34% 13%
Merchandise inventory 21% 23%
Other current assets 3% 4%
Total current assets 58% 41%
Property and Equipment
Leasehold improvements 23% 28%
Furniture and equipment 35% 43%
Land and buildings 10% 12%
Construction in progress 2% 3%
69% 86%
Accumulated depreciation and amortization -31% -32%
Propertyand equipment, net 38% 54%
Lease rights and other assets 4% 5%
Total assets 100% 100%

Liabilities and Shareholders' Equity


Current Liabilities
Notes payable 0% 1%
Cuurent maturities of long-term debt 5% 0%
Accounts payable 12% 16%
Accrued expenses and other current liabilities 11% 11%
Total current liabilities 28% 28%
Long-Term Liabilities
Long-term debt 15% 26%
Senior convertible notes 14% 0%
Deferred lease credits and other liabilities 6% 8%
Total long-term liabilities 36% 33%
Shareholders' Equity:
Common Stock, $.05 par value 0% 1%
Authorized 2,300,000,000 shares; issued 968,010,453 and 948,597,949 shares;
outstanding 887,322,707and 865,726,890 shares

Additional paid-in capital 6% 6%


Retained earnings 53% 64%
Accumulated other comprehensive loss 0% -1%
Deferred compensation 0% 0%
Treasury stock, at cost -23% -30%
Total shareholders' equity 37% 39%
Total liabilities and shareholders' equity 100% 100%

The company’s notes found in its annual report are an integral part of this statement.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 79

e10vkFigure 1.06 Intel’s Statement of Stockholders’ Equity Page 68 of 134


This figure describes changes in Intel’s stockholder equity: The columns are items reported in the Stockholders’
Equity section of Intel’s balance sheet. The rows are balances reported at year end and the interim events that
caused them to change.
Table of Contents Line Items in Stockholders’ Equity Section of Balance Sheet

INTEL CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

Acquisition-
Common Stock Related Accumulated
and Capital Unearned Other
in Excess of Par Value Stock Compre-
Three Years Ended December 29, 2007 Number of Compen- hensive Retained
(In Millions, Except Per Share Amounts) Shares Amount sation Income (Loss) Earnings Total
Balance at December 25, 2004 6,253 $ 6,143 $ (4) $ 152 $ 32,288 $ 38,579
Components of comprehensive income, net of tax:
Net income — — — — 8,664 8,664
Events Other comprehensive income — — — (25) — (25)
Total comprehensive income 8,639
that
Proceeds from sales of shares through employee equity
occurred incentive plans, tax benefit of $351, and other 84 1,553 — — — 1,553
Assumption of acquisition-related stock options and
during amortization of acquisition-related unearned stock
2005 compensation, net of adjustments — 2 4 — — 6
Repurchase and retirement of common stock (418) (1,453) — — (9,184) (10,637)
Cash dividends declared ($0.32 per share) — — — — (1,958) (1,958)
Balance at December 31, 2005 5,919 6,245 — 127 29,810 36,182
Components of comprehensive income, net of tax:
Net income — — — — 5,044 5,044
Events Other comprehensive income — — — 26 — 26
Total comprehensive income 5,070
that
Adjustment for initially applying SFAS No. 158, net of
occurred tax — — — (210) — (210)
Proceeds from sales of shares through employee equity
during incentive plans, net excess tax benefit, and other 73 1,248 — — — 1,248
2006 Share-based compensation — 1,375 — — — 1,375
Repurchase and retirement of common stock (226) (1,043) — — (3,550) (4,593)
Cash dividends declared ($0.40 per share) — — — — (2,320) (2,320)
Balance at December 30, 2006 5,766 7,825 — (57) 28,984 36,752
Cumulative-effect adjustments, net of tax1:
Adoption of EITF 06-02 — — — — (181) (181)
Adoption of FIN 48 — — — — 181 181
Events Components of comprehensive income, net of tax:
that Net income — — — — 6,976 6,976
Other comprehensive income — — — 318 — 318
occurred Total comprehensive income 7,294
during Proceeds from sales of shares through employee equity
incentive plans, net excess tax benefit, and other 165 3,170 — — — 3,170
2007 Share-based compensation — 952 — — — 952
Repurchase and retirement of common stock (113) (294) — — (2,494) (2,788)
Cash dividends declared ($0.45 per share) — — — — (2,618) (2,618)
Balance at December 29, 2007 5,818 $ 11,653 $ — $ 261 $ 30,848 $ 42,762

1 See “Accounting Changes” in “Note 2: Accounting Policies” for further discussion of the cumulative-effect
adjustments recorded at the beginningThe
of company’s
fiscal yearnotes
2007.found in its annual report are an integral part of this statement.

See accompanying notes.

50

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


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80 Navigating Accounting

Figure 1.07 Nike’s Statement of Stockholders’ Equity


This figure describes changes in Nike’s stockholder equity.

The company’s notes found in its annual report are an integral part of this statement.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 81

Figure 1.08 Disney’s Statement of Owners’ Equity


This figure describes changes in Disney’s stockholder equity.

The company’s notes found in its annual report are an integral part of this statement.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


®
82 Navigating Accounting

CHAPTER SOLUTIONS
Solution to Exercise 1.01
(a) Figure 1.01 illustrates how the balance-sheet equation applies to
Intel’s 2007 and 2006 year-end balance sheets. At the end of 2006,
Intel recognized $48,368 (million) of Total assets, $36,752 of
Stockholders’ equity and $11,616 (=$48,368 - $36,752) of liabilities.

Owners'
Assets = Liabilities +
equities

Intel
$48,368 = $11,616 + $36,752
year-end 2006

Intel
$55,651 = $12,889 + $42,762
year-end 2007

(b) At the end of 2006:


• Intel classified $18,280 of its assets as current assets and we can
determine that $30,088 (=$48,368 - $18,280) were implicitly
classified non-current.
• Intel classified $8,514 of its liabilities as current liabilities and we
can determine that $3,102 were implicitly classified non-current
($1,848 Long-term debt + $265 Deferred tax liabilities + $989
Other long-term liabilities).

Current Non-current Current Non-current Owners'


+ = + +
assets assets liabilites liabilities equities

Intel
$18,280 + $30,088 = $8,514 + $3,102 + $36,752
year-end 2006

Intel
$23,885 + $31,766 = $8,571 + $4,318 + $42,762
year-end 2007

(c) False: At the end of 2007, Intel owes creditors, not debtors, current
liabilities that must be paid within one year.
(d) True: At the end of 2007, Intel recognizes $23,885 of current assets
that it expects to realize benefits from in the near future.
(e) True: Intel is a debtor to at least one government at the end of 2007
because it recognizes $339 of income taxes payable.
(f ) False: Intel’s balance sheet recognizes $55,651 of equity claims at the
end of 2007, of which $42,762 are stockholders’ claims, the balance
is creditors’ claims.

© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson


Chapter 1: Introduction to Balance Sheets 83

Solution to Exercise 1.02


(a) Here is the completed BSE matrix for CreativeABCs:

Owners'
Assets = Liabilities +
Equity

+ C + StInv + Inven = + AP + CS
December 1, 2010 + + $0 + + $0 + + $0 = + + $0 + + $0
E1 Issue stock + + 10,000 + + = + + + 10,000
E2 Purchase debt securities + - 5,500 + + 5,500 + = + +

E3 Purchase inventory on account + + + + 4,000 = + + 4,000 +

December 2, 2010 + + $4,500 + + $5,500 + + $4,000 = + + $4,000 + + $10,000

(b) Here are the completed mini matrices for the three events:

CreativeABC Mini BSE:December 1 - 2, 2010


E1: Issue stock

Assets = Owners' Eq.


+ C = + CS
+ + 10,000 = + + 10,000

CreativeABC Mini BSE:December 1 - 2, 2010


E2: Purchase debt securities

Assets =
+ C + StInv =
+ - 5,500 + + 5,500 =

CreativeABC Mini BSE:December 1 - 2, 2010


E3: Purchase inventory on account

Assets = Liabilities
+ Inven = + AP
+ + 4,000 = + + 4,000

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84 Navigating Accounting

(c) Here is how the balance sheet can be created from the BSE matrix:

CreativeABC Company Balance Sheet


After first three events in December, 2010.

Assets 02-Dec-10 01-Dec-10


Current
Cash $4,500 $0
Short-term investments 5,500 0
Inventories 4,000 0
Owners'
Assets = Liabilities + Total current assets 14,000 0
Equity
Non-current 0 0
+ C + StInv + Inven = + AP + CS
Total assets $14,000 $0
December 1, 2010 + + $0 + + $0 + + $0 = + + $0 + + $0
E1 Issue stock + + 10,000 + + = + + + 10,000
Liabilities and Stockholders' Equity
E2 Purchase debt securities + - 5,500 + + 5,500 + = + + Liabilities
E3 Purchase inventory on account + + + + 4,000 = + + 4,000 + Current
December 2, 2010 + + $4,500 + + $5,500 + + $4,000 = + + $4,000 + + $10,000 Accounts payable 4,000 0
Total current liabilities 4,000 0
Non-current 0 0
Total liabilities 4,000 0
Stockholders' equity
Common stock 10,000 0
Total stockholders' equity 10,000 0
Total liabilities and stockholders' equity $14,000 $0

(d) The following three figures illustrate how E1-E3 affect the balance
sheet created in part (c):

CreativeABC Company Balance Sheet


After first three events in December, 2010.

Assets 02-Dec-10 01-Dec-10


Current
Cash $4,500 $0
Short-term investments 5,500 0
Inventories 4,000 0
Owners'
Assets = Liabilities + Total current assets 14,000 0
Equity
Non-current 0 0
+ C + StInv + Inven = + AP + CS
Total assets $14,000 $0
December 1, 2010 + + $0 + + $0 + + $0 = + + $0 + + $0
E1 Issue stock + + 10,000 + + = + + + 10,000
Liabilities and Stockholders' Equity
E2 Purchase debt securities + - 5,500 + + 5,500 + = + + Liabilities
E3 Purchase inventory on account + + + + 4,000 = + + 4,000 + Current
December 2, 2010 + + $4,500 + + $5,500 + + $4,000 = + + $4,000 + + $10,000 Accounts payable 4,000 0
Total current liabilities 4,000 0
Non-current 0 0
Total liabilities 4,000 0
Stockholders' equity
Common stock 10,000 0
Total stockholders' equity 10,000 0
Total liabilities and stockholders' equity $14,000 $0

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Chapter 1: Introduction to Balance Sheets 85

CreativeABC Company Balance Sheet


After first three events in December, 2010.

Assets 02-Dec-10 01-Dec-10


Current
Cash $4,500 $0
Short
r -term investments
Short-term inve
v stments 5,500 0
Inventories 4,000 0
Owners'
Assets = Liabilities + Total current assets 14,000 0
Equity
Non-current 0 0
+ C + StInv + Inven = + AP + CS
Total assets $14,000 $0
December 1, 2010 + + $0 + + $0 + + $0 = + + $0 + + $0
E1 Issue stock + + 10,000 + + = + + + 10,000
Liabilities and Stockholders' Equity
E2 Purchase debt securities + - 5,500 + + 5,500 + = + + Liabilities
E3 Purchase inventory on account + + + + 4,000 = + + 4,000 + Current
December 2, 2010 + + $4,500 + + $5,500 + + $4,000 = + + $4,000 + + $10,000 Accounts payable 4,000 0
Total current liabilities 4,000 0
Non-current 0 0
Total liabilities 4,000 0
Stockholders' equity
Common stock 10,000 0
Total stockholders' equity 10,000 0
Total liabilities and stockholders' equity $14,000 $0

CreativeABC Company Balance Sheet


After first three events in December, 2010.

Assets 02-Dec-10 01-Dec-10


Current
Cash $4,500 $0
Short-term investments 5,500 0
Inventories
Inve
v ntories 4,000 0
Owners'
Assets = Liabilities + Total current assets 14,000 0
Equity
Non-current 0 0
+ C + StInv + Inven = + AP + CS
Total assets $14,000 $0
December 1, 2010 + + $0 + + $0 + + $0 = + + $0 + + $0
E1 Issue stock + + 10,000 + + = + + + 10,000
Liabilities and Stockholders' Equity
E2 Purchase debt securities + - 5,500 + + 5,500 + = + + Liabilities
E3 Purchase inventory on account + + + + 4,000 = + + 4,000 + Current
December 2, 2010 + + $4,500 + + $5,500 + + $4,000 = + + $4,000 + + $10,000 Accounts payable 4,000 0
Total current liabilities 4,000 0
Non-current 0 0
Total liabilities 4,000 0
Stockholders' equity
Common stock 10,000 0
Total stockholders' equity 10,000 0
Total liabilities and stockholders' equity $14,000 $0

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86 Navigating Accounting

Solution to Exercise 1.03


(a) Property, plant and equipment, net likely recognizes the historical cost
of Nike’s corporate headquarters, net of its accumulated depreciation.
(b) Identifiable intangible assets and goodwill, net recognizes patents
and trademarks acquired from other companies. The future benefits
associated with these patents is the legal protection they provide Nike
against competitors selling similar products.
(c) Inventories recognizes shoes that Nike had produced but not yet sold
on May 31, 2002.
(d) False. Nike does not disclose goodwill as a separate line item. The
recognized goodwill is aggregated with the recognized identifiable
intangible assets.
(e) False. Nike expects to collect $1,807.1 at the end of fiscal 2002 but it
is owed $1,884.5 ($1,807.1 + $77.4).
(f ) True: The net in “Property, plant, and equipment, net” indicates
that property plant and equipment is reported at historical cost less
accumulated depreciation.
(g) False. There was a $50.3 net change in the account, which reflects the
net effect of several events including the cost of new inventories less
the cost of sold inventories.
(h) An asset that is recognized by both companies that is separately
disclosed by Intel but is not disclosed by Nike is goodwill.
(i) “Deferred tax assets” in the current asset section of Intel’s balance
sheet likely represents the same concept as “Deferred income taxes” in
the current asset section of Nike’s balance sheet.

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Chapter 1: Introduction to Balance Sheets 87

Solution to Exercise 1.04


(a) (1) Cash and cash equivalents have numerous future benefits. Cash
equivalents can be converted easily to cash that can be used to acquire
resources, meet obligations, purchase the companies’ common
stock from shareholders (repurchase stock), or pay dividends. (2)
The benefit of having spare parts, supplies, and fuel on hand is that
Federal Express can respond to its customers’ needs more quickly
(than it could without these assets). Imagine the operating problems
that would occur if Federal Express had to order parts from a supplier
every time there was an equipment failure.
(b) (1) When customers purchase services from Federal Express on
account, Federal Express records a receivable for the amount owed by
the customer. The risk associated with receivables is that they will not
be collected either because the seller (Federal Express) does not honor
its part of the sales agreement (e.g., fails to deliver a package on time)
or because the customer does not honor its part of the agreement
(e.g., does not pay Federal Express for a delivered package). (2) The
risks associated with aircraft and related equipment are that it will
become damaged or that demand for its services will decline because
of obsolescence or general economic conditions. (3) Likewise, damage
and obsolescence are the primary risks associated with computers and
electronic equipment. However, obsolescence is generally a larger risk
than damage for computers and other high-tech equipment.
(c) (1) Cash and cash equivalents can be measured very reliably since
cash equivalents are highly liquid assets that are widely traded and
the prices of these trades are readily available to the public. (2-3)
Used Aircraft and related equipment, package handling, and ground
support equipment are traded considerably less frequently than cash
equivalents. Equipment with comparable ages and usage are likely
traded infrequently. Also, the prices of these trades are likely not
available in one place and thus, while the fair value of used aircraft,
package handling, and ground support equipment can be estimated
from those prices that are available to a company, these estimates are
considerably less reliable than those for cash equivalents. The fair
values of vehicles such as Federal Express’ used delivery trucks can
likely be measured more reliably than aircraft, package handling, and
ground support equipment since these vehicles are traded frequently
and the average prices of comparable used vehicles are readily
available.
(d) Federal Express would likely write down its receivables if there was
a downturn in the economy and it concluded that more customers

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88 Navigating Accounting

would likely default on their obligations to Federal Express in the


future than had previously been expected.
(e) The primary advantage of allowing companies to write-up their
property, plant and equipment to fair values would be that users of
financial information generally would get more relevant information
for their decisions. For example, if an investor was estimating
the value of a company that had accumulated considerable real
estate holdings over the years that had appreciated in value, she
would prefer to know the fair value of this real estate rather than
the cumulative amount it was purchased for in the past net its
accumulated depreciation. The disadvantages of allowing companies
to recognize property, plant, and equipment at fair value are: (i) that
it is difficult for honest outside assessors to measure them reliably,
and (ii) its is difficult to detect when outside assessors exaggerate fair
values to encourage the companies that hire them to hire them again
in the future.
(f ) Nike and Intel sell goods that are stored in inventories prior to
delivery. By contrast, Federal Express sells services (deliveries) rather
than goods.

Solution to Exercise 1.05


(a) Typically notes payable reports short term obligations to banks and
other creditors who have loaned money to a company that has yet
to be repaid. Note 4 of Nike’s footnotes indicates that Notes payable
includes notes payable to banks.
(b) False. Two liabilities disclosed on Federal Express’ balance sheet
pertain to long-term debt and a total of $1,806 is outstanding: (i)
the $6 current-portion recognized in the current liabilities; plus (ii)
the $1,800 non-current portion recognized as “Long-term debt, less
current portion.”
(c) $681.2 = $55.3 (current portion) + $625.9 (Long-term debt). Notice
that Nike assumes that because of the location of “Long-term debt”
on the balance sheet, readers will understand that this item represents
the non-current portion of long-term debt only.
(d) False. We can not safely say that no taxes were owed. Disclosure is
not the same as recognition. The fact that an income tax liability is
not disclosed means that if one was recognized, it was considerably
smaller than the other liabilities that were disclosed and likely

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Chapter 1: Introduction to Balance Sheets 89

included in another line item. For example, while we can not be


certain, it is likely that income taxes payable are included in Accrued
expenses. Recall that liabilities are accrued when a company owes
creditors money for services they have already provided to the
company that helped the company produce or sell its own goods or
services. While it is unusual to include income taxes in this line item,
governments do provide services prior to payment of taxes (use of
roads, police protection, etc.). It is also possible that income taxes
payable is included in accounts payable. However, this item is usually
reserved for amounts owed to suppliers.
(e) Accrued expenses on Federal Express’ balance sheet and Accrued
advertising and Other accrued liabilities on Intel’s balance sheet
closely resemble Accrued liabilities on Nike’s balance sheet.
(f ) True. Accrued liabilities are amounts owed to creditors for past
service.
(g) As indicated below, FedEx had the most total liabilities. Note that
Nike implicitly classifies redeemable preferred stock as a liability.
Preferred stock is a hybrid security that has some debt traits and some
owners’ equity traits. Some companies classify it as debt and others as
owners’ equity.

Nike FedEx
(millions) (millions)
Current liabilities $1,836.2 $2,942.0
Long-term debt $625.9 $1,800.0
Deferred Income taxes $141.6 $599.0
Other liabilities $0.0 $1,926.0
Commitments and contingencies $0.0 $0.0
Redeemable preferred stock $0.3 $0.0
Total liabilities $2,604.0 $7,267.0

(h) As indicated below, Federal Express had the most total liabilities as a
percent of total assets:

Nike FedEx
(millions) (millions)
Total liabilities $2,604.0 $7,267.0
Total assets $6,443.0 $13,812.0
Total liabilities as percent of total assets 40.42% 52.61%

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90 Navigating Accounting

(i) As indicated below, Nike had the most working capital:

Nike FedEx
(millions) (millions)
Current assets $4,157.7 $3,665.0
Current liabilities $1,836.2 $2,942.0
Working capital $2,321.5 $723.0

(j) Here are some weaknesses of using working capital as a measure of


whether the company will have enough cash to meet its liabilities
during the upcoming year:
(1) The liquidation value of the current assets might be less than
the amount recognized on the balance sheet. For example, if a
company is forced to sell its inventories at a time when it is facing
financial difficulties, it might have to lower prices to the point
where is sells them for less than the recognized amounts.
(2) If a company uses some of the current assets recognized at year
end for purposes other than meeting current liabilities (e.g.,
uses cash to pay a dividend to shareholders at the start of the
next year), it might not have enough current assets to meet its
liabilities.
(3) The value of the company might be significantly higher than
recognized on the balance sheet and, as a result, the company
might be able to raise cash by issuing additional common stock
or debt. For example, the economic value of Intel’s assets exceeds
the amount recognized on the balance sheet because the value of
assets such as the patents that Intel developed internally are not
recognized on the balance sheet.
(k) False. Federal Express will only owe this deferred tax liability if it has
future taxable income. This is a contingent claim.

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Chapter 1: Introduction to Balance Sheets 91

Solution to Exercise 1.06


(a) Here is an acceptable balance sheet. Do not be concerned if your
format differs slightly from this one.

Consolidated Balance Sheet


1/1/2008
Assets
Current assets:
Cash and equivalents $1,000
Total current assets $1,000
Total assets $1,000

Liabilities and stockholders' equity


Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value $1,000
Total stockholders' equity $1,000
Total liabilities and stockholders' equity $1,000

(b) Three conditions must be met to satisfy the definitional criterion for
asset recognition and all three are met for the business plan:
(1) The business plan is a resources that provides future benefits
— it will be used in the future to guide SimpleSales’ operating,
investing, and financing decisions.
(2) The business plan is owned or controlled by the company — Wil
Carlstedt contributed the business plan to SimpleSales and thus
the company owns the plan.
(3) The ownership or control arose from past transactions or events
— Wil Carlstedt contributed the business plan prior to the
balance sheet date (end of January 1, 2008).
This exercise demonstrates that some assets are not
recognized on balance sheets. The business plan is an
asset (because it meets the definitional criterion) but it is not
recognized on the balance sheet because in the opinion of
those who establish GAAP, it can not be measured reliably.

(c) The business plan likely fails to meet the measurability criterion for
asset recognition because:
(1) Expert assessors’ fair value estimates would probably be widely
dispersed and
(2) It is possible that SimpleSales could find an unscrupulous expert
who would be willing to issue a biased, favorable assessment for
the right price.

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92 Navigating Accounting

• These measurement problems disappear or are mitigated


when market prices are available, especially for highly
liquid assets, or when similar assets have been exchanged
recently by unrelated parties and the prices of these
transactions are available.
• Individuals often assess different fair values for the same
asset. Still, individuals’ fair-value assessments tend to cluster
closely to market values when assets are widely traded. For
this reason, when GAAP requires that assets be recognized
at fair value and market values are readily available, GAAP
generally specifies that they be reported. For example, if
Intel owned IBM stock, the stock price would be readily
available so Intel would estimate the fair value of this stock
using the share price at the close of trading on the balance
sheet date.

(d) Here is the balance sheet that SimpleSales would report if business
plans were recognized under GAAP at their “fair values” (Wil’s banker
friend is hardly an unrelated party). Assuming that the business plan
will provide benefits for more than one year, it should be classified as
a non-current asset. Here it is classified as “other assets” but arguably
“long-term investments” would also be appropriate.

Consolidated Balance Sheet


1/1/2008
Assets
Current assets:
Cash and equivalents $1,000
Total current assets $1,000
Other assets $4,000
Total assets $5,000

Liabilities and stockholders' equity


Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value $5,000
Total stockholders' equity $5,000
Total liabilities and stockholders' equity $5,000

(e) Pros: Those who would favor recognition might argue that because
this asset is not recognized, the balance sheet fails to meet its purpose
— “to help financial statement users assess a company’s financial
position at this time.” Even if they agreed that the fair value of the
business plan is difficult to estimate, they might argue that: (1) it is
definitely worth more than $0, which is its implicit book value when
it is not recognized; (2) unless the bankers’ $4,000 fair-value estimate
is a gross exaggeration, it would seem that SimpleSales is leaving its

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Chapter 1: Introduction to Balance Sheets 93

biggest asset off its balance sheet; and (3) other potential investors
could ignore or adjust reported fair-value estimates if they choose to
do so.
Cons: Opponents would argue that fair values can be very unfair
when assets are difficult to measure reliably, particularly when
companies have incentives to manipulate their numbers and
opportunities to act on these incentives. For example, Enron was
accused of exaggerating its fair value estimates to manipulate its stock
price.

Solution to Exercise 1.07


(a) Here is the January 2, 2008 balance sheet assuming cash and the
purchased clothes are the only recognized assets:

Consolidated Balance Sheet


1/2/2008
Assets
Current assets:
Cash and equivalents $1,000
Inventories $600
Total current assets $1,600
Total assets $1,600

Liabilities and stockholders' equity


Current liabilities:
Accounts payable $600
Total current liabilities $600

Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value $1,000
Total stockholders' equity $1,000
Total liabilities and stockholders' equity $1,600

(b) As indicated in the above balance sheet, the book values of


FancyFashions’ creditor claim and Wil Carlstedt’s owners’ equity
claim are $600 and $1000, respectively. Assuming that the business
plan has a fair value of $4,000, the fair value of FancyFashions’ claim
is still $600 (since this is the amount owed) but the fair value of Wil
Carlstedt’s claim becomes $5,000.
(c) From a book value perspective, FancyFashions has a $600 first claim
on the $1,200 of assets and Wil Carlstedt has a $600 common-stock
residual claim on the $1,200 of assets. From a fair value perspective,
assuming that the business plan still has a fair value of $4,000 after
the fashion article is posted to the web on January 3, 2008, the fair
values of FancyFashions’ creditor claim is still $600 since this amount
is owed regardless of retail prices. The fair value of Wil Carlstedt’s
owners’ equity claim decreases to $4,600 since he expects a $400 loss
on the merchandise ($600 - $200).

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94 Navigating Accounting

(d) Here is the January 3, 2008 balance sheet given the assumptions:

Consolidated Balance Sheet


1/3/2008
Assets
Current assets:
Cash and equivalents $1,000
Inventories $200
Total current assets $1,200
Total assets $1,200

Liabilities and stockholders' equity


Current liabilities:
Accounts payable $600
Total current liabilities $600

Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value $1,000
Retained earnings ($400)
Total stockholders' equity $600
Total liabilities and stockholders' equity $1,200

Solution to Exercise 1.08


(a) Here is SimpleSales balance sheet at the end of January 5, 2008 given
the assumptions:

Consolidated Balance Sheet


1/5/2008
Assets
Current assets:
Cash and equivalents $950
Short-term investments $500
Inventories $450
Total current assets $1,900
Total assets $1,900

Liabilities and stockholders' equity


Current liabilities:
Accounts payable $600
Income taxes payable $120
Total current liabilities $720

Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value $1,000
Retained earnings $180
Total stockholders' equity $1,180
Total liabilities and stockholders' equity $1,900

(b) The creditors are FancyFashions and the government. As indicated


in the above balance sheet, the book value of their claims are $600
and $120, respectively. These are also the fair-value estimates of these
claims since these parties still expect to receive what they are owed. As

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Chapter 1: Introduction to Balance Sheets 95

indicated on the balance sheet, the book value of the owner’s claim is
$1,180. The fair market value of the owners’ claim is $5,180 because
it reflects the fair values of assets that are not recognized on the
balance sheet (e.g., the business plan).
(c) The $1,180 book value of the owners claim is represented by two
balance sheet components: (1) $1,000 of common stock, which
recognizes the historical value of the resources (cash) that Wil
Carlstedt contributed on January 1, 2008, and (2) $180 of retained
earnings, which represents the $180 of net income that accumulated
since the company was started.
(d) Here is the balance sheet for January 6, 2008 given the assumptions:

Consolidated Balance Sheet


1/6/2008
Assets
Current assets:
Cash and equivalents $950
Short-term investments $600
Inventories $450
Total current assets $2,000
Total assets $2,000

Liabilities and stockholders' equity


Current liabilities:
Accounts payable $600
Income taxes payable $120
Total current liabilities $720
Deferred tax liabilities $40
Stockholders' equity:
Common stock, $1 par value, 500 shares
authorized; 100 issued and outstanding
and capital in excess of par value $1,000
Accumuled other comprehensive income $60
Retained earnings $180
Total stockholders' equity $1,240
Total liabilities and stockholders' equity $2,000

(e) The $1,240 book value of the owners’ claim is represented by three
balance sheet components: (1) $1,000 of common stock, which
recognizes the historical value of the resources (cash) that Wil
Carlstedt contributed on January 1, 2008; (2) $60 of accumulated
other comprehensive income (net of taxes), which represents the
unrealized gain net of taxes on the marketable securities; and (3) $180
of retained earnings, which represents the $180 of net income that
accumulated since the company was started.

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96 Navigating Accounting

Solution to Exercise 1.09


(a) For Intel, the four most significant items at the end of 2007 are: cash
and equivalents (13% of assets); property, plant, and equipment, net
(30%); common stock (21%); and retained earnings (55%).
For Gap, the most significant items at the end of the most current
year are: cash and equivalents (34% of assets); property, plant, and
equipment (38%); retained earnings (53%); and treasury stock
(23%).
(b) The biggest asset for both Intel and Gap is property, plant and
equipment, net (PP&E). For Intel, the size of this asset largely reflects
the high cost of equipment in wafer fabrication plants and the need to
continually build new ones to keep up with technological innovation.
For Gap, the size of this asset is largely due to the cost to furnish
stores. Most of the stores are leased and these leases are classified as
operating leases, which means the leases are not recognized on the
balance sheet.
Characteristic of retail merchandising companies, inventories
comprise a much larger percent of Gap’s balance sheet than they do
for Intel.
A large portion of Intel’s balance sheet is liquid assets such as cash and
short-term securities. Intel has been remarkably profitable in the past
and needs liquidity to finance R&D and capital expenditures.
Intel has considerably less financial leverage than Gap. Intel’s total
liabilities are 23% of assets at the end of 2007. By contrast, Gap’s
total liabilities are 64% of assets (28% + 36%).
Retained earnings comprises a relatively large percent of assets for
both companies. However, Gap would report smaller retained
earnings if it recorded stock repurchases the same way as Intel.
Gap records stock repurchases as treasury stock (a contra equity)
while Intel deducts them directly from common stock and retained
earnings. Both approaches are perfectly acceptable under GAAP.

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Chapter 1: Introduction to Balance Sheets 97

Solution to Exercise 1.10


(a) For fiscal 2002, Nike and Disney recognized $663.3 and $1,236 of
net income, respectively.
(b) For fiscal 2002, Nike and Disney recognized $128.6 and $428 of
common stock dividends, respectively.
(c) The combined balance-sheet consequences of declaring and paying
a dividend are that cash and retained earnings both decrease by the
amount of the dividend. The cash decrease signifies that cash has left
the company and thus there are fewer assets than there were before
the dividend was paid. The decrease in retained earnings and thus
stockholders’ equity signifies that owners’ claims are not worth as
much because assets decreased and the owners (rather than creditors)
received the cash. Notice that the cash the owners receive exactly
compensates for the decrease in the value of their claims.
(d) During fiscal 2002, Nike and Disney issued 1.7 million shares and
3 million shares, respectively, because employees exercised stock
options.
(e) Net income and dividends are two common items that explain
changes in the companies’ retained earnings during fiscal 2002.
(f ) False: Nike recognized ($192.4) accumulated other comprehensive
income at the end of fiscal 2002. During fiscal 2002, Nike recognized
$(40.3) of other comprehensive income. The lesson here is that
balance sheets recognize amounts at a point in time (e.g., year end)
but statements of shareholders equities also report changes during the
reporting period.
(g) True: Nike recognized $623.0 of comprehensive income during fiscal
2002, which was comprised of $663.3 net income plus $(40.3) of
other comprehensive income.
(h) True: Disney recognized a net loss of $158 from its primary
businesses during fiscal 2001.
(i) True: Disney recognized common stock dividends in 2000, 2001 and
2002.
(j) True: Disney recognized $38 and ($95) of other comprehensive
income during 2001 and 2002, respectively.
(k) The components of comprehensive income provide very different
types of information about a company’s future performance.
Generally, past and current years’ net incomes are better predictors of

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98 Navigating Accounting

future net income than past and current years’ other comprehensive
income is a predictor of future other comprehensive income.
For example, absent strong evidence to the contrary, the fact that
Intel has done well in its primary business for several years suggests
that it will do well in the future. In fact, research suggests that future
net income can be forecasted relatively reliably from historical data.
By contrast, forecasts of interest rates, stock prices, currency exchange
rates and other economic factors associated with other comprehensive
income are generally much less reliable.
Solution to Exercise 1.11
The solution for this exercise is on the Navigating Accounting CD,
Chapter 1 PowerPoint slides. The CD will be given out during class.

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