Balance Sheet Component

Chapter 2
The Balance Sheet

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall 2-1
Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall
The Balance Sheet
Also called the statement of
condition or the statement of
financial position
Shows the financial condition of
a company on a particular date
Summarizes what the firms owns
and what the firm owes to
outsiders and to internal owners
2-2
Financial Condition

Assets are what the firm owns.
Liabilities are what the firm owes
to outsiders.
Stockholders equity is what the
firm owes to internal owners.
equity rs' Stockholde s Liabilitie Assets
2-3
Financial Condition
Consolidation
Parent company owns more
than 50% of voting stock.
Financial statements are
combined.
2-4
Financial Condition
Balance Sheet Date
The date the balance sheet is
prepared
Could be the end of the
calendar year, fiscal year,
quarter, etc.
2-5
Financial Condition
Comparative Data
SEC requires two-year audited
balance sheets.
Provides a reference point for
determining changes in
financial position
2-6
Financial Condition
Common-Size Balance Sheet
Expresses each item on the balance sheet as a
percentage of total assets
Reveals the composition of assets
Form of vertical ratio analysis
Useful for evaluating trends within a firm
Allows for making industry comparisons
2-7
Financial Condition
2-8
Assets
Segregated according to how they
are utilized
Current Assets
Property, Plant, and
Equipment
Other Assets
2-9
Assets
Current Assets
Expected to be converted to
cash within one year or one
operating cycle
Continually used up and
replenished
2-10
Assets
Current Assets
Operating cycle
Time required to purchase or
manufacture inventory, sell the
product, and collect the cash
Working capital
Also called net working capital
Current assets less current liabilities
2-11
Assets
Current Assets
Cash and cash equivalents
Marketable securities
Accounts receivable
Inventories
Prepaid expenses
2-12
Assets
2-13
Assets
Current Assets Cash and Cash
Equivalents
Cash awaiting deposit
Cash in a bank account
Short-term investments that can
be converted to cash within three
months
2-14
Assets
Current Assets Marketable
Securities
Short-term investments that can be
converted to cash within a year
Three categories
Held to maturity
Trading securities
Securities available for sale
2-15
Assets
Current Assets Accounts
Receivable
Customer balances outstanding
on credit sales
Net realizable value actual
amount of account less an
allowance for doubtful accounts
2-16
Assets
Receivable
Allowance for doubtful accounts
Affects balance sheet valuation
Important in assessing earnings quality
Should reflect volume of credit sales, past
experiences with customers, customer
base, credit policies, collections practices,
and economic conditions
2-17
Assets
The allowance account for Sage Inc.
represents approximately 5% of
accounts receivable:
2-18
Assets
Receivable
There should be a consistent
relationship between the rate
of change in sales, accounts
receivable, and the allowance
for doubtful accounts.
2-19
Assets
Sage Inc.
2-20
Assets
To analyze the preceding information, consider
the following:
Are all three accounts changing in the same
directions and at consistent rates of change?
If the direction and rates of change are not
consistent, what are possible explanations for
these differences?
If there is not a normal relationship between
the growth rates, what are possible reasons
for the abnormal pattern?
2-21
Assets
For Sage Inc.,
Sales, accounts receivable, and the allowance
for doubtful accounts have all increased.
Allowance account has increased
appropriately in relation to accounts
receivable.
Sales have grown at a much greater rate.
More sales in cash have probably been
collected.
Sage will probably experience fewer defaults.
2-22
Assets
Current Assets Accounts Receivable
Additional information helpful to the
analysis of accounts receivable and
the allowance account is provided in
the schedule of Valuation and
Qualifying Accounts.
Additions Charged to Costs and
Expenses
Deductions
2-23
Assets
2-24
Assets
Additions Charged to Costs and Expenses is the
amount estimated and recorded as bad debt
expense each year on the income statement.
Deductions is the actual amount the firm has
written off as accounts receivable they no longer
expect to recover.
Analyst should use this schedule to assess the
probability that the firm is intentionally over- or
underestimating the allowance account.
Sage Inc. appears to estimate an expense fairly
close to the actual amount written of each year.
2-25
Assets
Current Assets Inventories
Items held for sale
Items used in the manufacture
of products that will be sold
Major revenue producer for
most companies
2-26
Assets
Retail companies
Finished goods
Manufacturing companies
Raw materials
Work-in-process
Finished goods
Service oriented companies
Little to no inventory

2-27
Assets
2-28
Assets
Inventory Accounting Methods
Method used has considerable impact on financial
position and operating results.
Valuation is based on an assumption regarding the
flow of goods, not the actual order in which
products are sold.
Cost flow assumption is made in order to match
the cost of products sold to the revenue generated.
Disclosure of inventory cost flow assumption is
found in the notes.
2-29
Assets
First in, first out (FIFO)
Last in, first out (LIFO)
Average cost
2-30
Assets
2-31
Assets
Example A new company in its first
year of operations purchases five products
for sale in the order and at the prices
shown. The company sells three of these
items at the end of the year.
Item Purchase Price
#1 $5
#2 $7
#3 $8
#4 $9
#5 $11
2-32
Assets
Cost flow assumptions

Resulting effect on the income statement and
balance sheet
2-33
Assets
During a period of inflation, the LIFO
method typically produces
the highest cost of goods sold expense
the lowest ending valuation of inventory
undervalued inventories on the balance
sheet
cost of goods sold values at current cost of
inventory items
2-34
Assets
During a period of inflation, the FIFO
the lowest cost of goods sold expense
the highest ending valuation of inventory
inventory values on the balance sheet that
are at current cost
cost of goods sold values below the current
cost of inventory items
2-35
Assets
During a period of deflation, the FIFO
the highest cost of goods sold expense
the lowest ending valuation of inventory
undervalued inventories on the balance
sheet
cost of goods sold values at current cost of
inventory items
2-36
Assets
During a period of deflation, the LIFO
the lowest cost of goods sold expense
the highest ending valuation of inventory
inventory values on the balance sheet that
are at current cost
cost of goods sold values below the current
cost of inventory items
2-37
Assets
Current Assets Prepaid Expenses
Expenses paid in advance
Insurance
Rent
Property taxes
Utilities
Included in current assets if they expire within
one year or one operating cycle
Generally not material to the balance sheet
2-38
Assets
Property, Plant, and Equipment (PP&E)
Encompasses a companys fixed assets
Not used up during annual operations
Produce economic benefits for more than one
year
Have physical substance
Shown at book value on the balance sheet
2-39
Assets
Property, Plant, and Equipment (PP&E)
The relative proportion of fixed assets in a
companys asset structure will largely be
determined by the nature of the business.
Manufacturing firms typically have higher
percentages of fixed assets than retailers or
wholesalers.
Firms with newly purchased assets will have
higher percentages of fixed assets than firms
with older fixed assets.

2-40
Assets
2-41
Assets
Property, Plant, and Equipment
Land
Buildings
Leasehold improvements
Construction in progress
Equipment
2-42
Assets
PP&E Land
Property used in business
Not investment property
2-43
Assets
PP&E Buildings
Buildings owned by the
company
Stores
Corporate offices
2-44
Assets
PP&E Leasehold Investments
Additions made to leased structures
Improvements made to leased
structures
Revert to the property owner when the
lease expires
Amortized by the lessee over the
economic life of the improvement (or
the life of the lease)
2-45
Assets
PP&E Construction in Progress
Costs of constructing new
buildings that are not yet
complete
2-46
Assets
PP&E Equipment
Original cost of machinery and
equipment used in business
operations
2-47
Assets
PP&E Depreciation
Fixed assets (with the exception of
land) are depreciated over the period
of time they benefit the firm.
Method of allocating the cost of
long-lived assets
Original cost less estimated residual
value is spread over the assets
expected life.

2-48
Assets
PP&E Depreciation Methods
Straight-line method allocated an
equal amount of expense to each
year of the depreciation period.
Accelerated methods apportions
larger amounts of expense to earlier
years of the assets depreciable life.
Units-of-production method bases
depreciation expense on actual use.

2-49
Assets
Example Assume that Sage Inc.
purchases an artificial ski mountain
for its Phoenix flagship store in
order to demonstrate skis and allow
prospective customers to test-run
skis on a simulated course. The
cost of the mountain is $50,000
and is expected to have a five-year
useful life and $0 salvage value at
the end of that period.
2-50
Assets
2-51
Assets
2-52
Assets
Goodwill
Arises when one company acquires another
company for a price in excess of the fair
market value of the net identifiable assets
acquired
Evaluated annually
If no loss of value has occurred, goodwill
remains on the balance sheet.
If the book value exceeds the fair value, the
excess must be written off as an impairment
expense
2-53
Assets
Other Assets
Can include a multitude of other noncurrent
items
Property held for sale
Start-up costs associated with a new business
Cash surrender value of life insurance
policies
Long-term advance payments
Intangible assets (other than goodwill)
2-54
Liabilities
Represent claims against assets
Current liabilities
Must be satisfied in one year or
one operating cycle
Noncurrent liabilities
Obligations with maturities beyond
one year
2-55
Liabilities
2-56
Liabilities
Current Liabilities
Accounts payable
Notes payable
Current portion of long-term
debt
Accrued liabilities
Unearned revenue
2-57
Liabilities
Current Liabilities Accounts Payable
Short-term obligations that arise
from credit extended by suppliers for
the purchase of goods and services
Eliminated when the bill is satisfied
Increase and decrease depending on
credit policies, economic conditions,
and cyclical nature of operations
2-58
Liabilities
Current Liabilities Notes Payable
Also referred to as short-term
debt
Short-term obligations in the
form of promissory notes
Lines of credit to suppliers or
financial institutions
2-59
Liabilities
Current Liabilities Current
Maturities of Long-term Debt
Portion of the principal of
long-term debt that will be
repaid during the upcoming
year
2-60
Liabilities
Current Liabilities Accrued Liabilities
Result from recognition of an expense prior
to actual payment of cash
Reserve accounts
Set up for the purpose of estimating
obligations for items such as warranty costs,
sales returns, or restructuring charges
Identified in the notes to the financial
statements
2-61
Liabilities
Current Liabilities Accrued Liabilities
Example Assume that a company has a $100,000
note outstanding with 12% interest due in semiannual
installments on March 31 and September 30. For a
balance sheet prepared on December 31, interest will
be accrued for three months (October, November,
and December). The December 31 balance sheet
would include an accrued liability of $3,000:

$10,000 x 0.12 = $12,000 annual interest
$12,000/12 = $1,000 monthly interest
$1,000 x 3 = $3,000 accrued interest for three months
2-62
Liabilities
Current Liabilities Unearned Revenue
Also called deferred credits
Result from payments received in
advance for services and products
Transferred to a revenue account
when the service is performed or the
product is delivered

2-63
Liabilities
Deferred Taxes
Result of temporary differences
in the recognition of revenue and
expense for taxable income
relative to reported income
Depreciation methods are the
most common source for
temporary differences.
2-64
Liabilities
Deferred Taxes
Other temporary differences arise from
methods used to account for
Installment sales
Long-term contracts and leases
Warranties and service contracts
Pensions and other employee benefits
Subsidiary investment earnings
2-65
Liabilities
Deferred Taxes
Permanent differences in
income tax accounting do not
affect deferred taxes.
Municipal bond revenue
Life insurance premiums
2-66
Liabilities
Deferred Taxes
Valuation allowance
Used to reduce deferred tax assets
to expected realizable amounts
Used when it is more likely than
not that some of the deferred tax
assets will not be realized
2-67
Liabilities
Example Assume that a company has a total
annual revenue of $500,000, expenses other
than depreciation of $250,000, and a
depreciation expense of $100,000 for tax
accounting and $50,000 for financial reporting.
The income for tax reporting purposes would be
computed two ways, assuming a 34% tax rate:
2-68
Liabilities
Taxes actually paid ($51,000) are less than
the tax expense ($68,000) reported in the
financial statements. To reconcile the
$17,000 difference between the expense
recorded and the cash outflow, there is a
deferred tax liability of $17,000:
2-69
Liabilities
2-70
Liabilities
Deferred Taxes
Deferred taxes are not always
classified as current liabilities.
They may also appear on the balance
sheet as a
current asset
noncurrent asset
noncurrent liability
2-71
Liabilities
Noncurrent Liabilities
Long-term debt
Capital lease obligations
Postretirement benefits other
than pensions
Commitments and contingencies
Hybrid securities
2-72
Liabilities
Noncurrent Liabilities Long-term Debt
Bonds
Long-term notes payable
Mortgages
Obligations under leases
Pension liabilities
Long-term warranties
2-73
Liabilities
Noncurrent Liabilities Capital Lease
Obligations
Are, in substance, a purchase rather
than a lease
Affect both balance sheet and income
statement
Disclosures found in the notes, often
under both the PP&E note and the
commitments and contingencies note
2-74
Liabilities
Noncurrent Liabilities Pensions and
Postretirement Benefits
Pensions are cash compensation paid to
retired employees.
Postretirement benefits are benefits
other than pensions that employers
promise to pay for retired employees.
Can appear under the liability section of
the balance sheet
2-75
Liabilities
Noncurrent Liabilities Commitments and
Contingencies
Commitments refer to contractual
agreements that will have a significant
financial impact in the future.
Contingencies refer to potential liabilities
(such as possible damage awards assessed in
lawsuits).
Intended to draw attention to the fact that
required disclosures can be found in the
notes to the financial statements.
2-76
Liabilities
Noncurrent Liabilities Hybrid
Securities
Have the characteristics of both debt
and equity
Also called mandatorily redeemable
preferred stock
Financial instrument is preferred
stock, but the issuing company must
retire the shares at a future date.
2-77
Stockholders Equity
Also called shareholders
equity
Residual interest in assets that
remains after deducting
liabilities
Owners bear greatest risk and
benefit from greatest rewards.
2-78
Stockholders Equity
Common Stock
Shareholders
do not ordinarily receive a fixed return
have voting privileges in proportion to
ownership interest
can benefit through price appreciation
can suffer through price depreciation
2-79
Stockholders Equity
Common Stock
Dividends are declared at the
discretion of a companys board of
directors
Amount listed on the balance sheet is
based on the par or stated value of the
shares issued (which bears no
relationship to actual market price).
2-80
Stockholders Equity
Additional Paid-In Capital
Reflects the amount by which
the original sales price of the
stock shares exceeded par
value
2-81
Stockholders Equity
Retained Earnings
Sum of every dollar a company has
earned since inception less any
payments made to shareholders
Funds a company has elected to
reinvest in the operations of the
business rather than pay out in stock
Measurement of all undistributed
earnings
2-82
Stockholders Equity
Retained Earnings
Key link between the income
statement and the balance sheet
Unless there are unusual
transactions affecting the retained
earnings account,
Beginning
retained
earnings
Net
income
(loss)
Ending
retained
earnings
Dividends =
2-83
Stockholders Equity
Other Equity Accounts
Preferred stock
Accumulated other comprehensive
income (expense)
Treasury Stock
Employee benefit trusts
Equity attributable to noncontrolling
interests
2-84
Stockholders Equity
2-85
Stockholders Equity
Other Equity Accounts
Preferred Stock
Carries a fixed annual dividend
payment
Carries no voting rights
2-86
Stockholders Equity
Other Equity Accounts Accumulated Other
Comprehensive Income (Expense)
Unrealized gains or losses in the market value of
investments in available-for-sale securities
Any change in the excess of additional pension
liability over unrecognized prior service cost
Certain gains and losses on derivative financial
instruments
Foreign currency translation adjustments
resulting from converting financial statements
from a foreign currency into U.S. dollars
2-87
Stockholders Equity
Other Equity Accounts Treasury Stock
Repurchased shares of stock that are
not retired
Shown as an offsetting account
2-88
Stockholders Equity
Other Equity Accounts Equity
Attributable to Noncontrolling
Interests
Represents the equity interest a firm
has in companies whose financial
statement have been consolidated
with the firms statements but that are
not 100% owned by the firm
2-89
Quality of Financial
Reporting
Economic recession of 2008 and many
market gyrations since can be traced directly
to overvaluation of balance sheet assets.
When financial reporting does not reflect
economic reality quality and usefulness are
significantly impaired.
Type of debt used to finance assets,
commitments and contingencies, and the
classification of leases relate directly to
quality of financial reporting.
2-90
Quality of Financial
Reporting
Commitments and Contingencies
disclosure in the notes to financial
statements provide important
information about off-balance sheet
financing and other complex
financing arrangements.
Enron is a prime example of a
company with enormous activity
reported in the Commitments and
Contingencies disclosure.
2-91
Other Balance Sheet Items
Corporate balance sheets are
not limited to the accounts
described in this chapter.
The reader of annual reports
will encounter additional
accounts and will find many of
the same accounts listed under
different titles.
2-92
Copyright Notice
All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic,
mechanical, photocopying, recording, or otherwise,
without the prior written permission of the publisher.
Printed in the United States of America.
2-93

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Chapter 2

The Balance Sheet

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