Structure of the

Balance Sheet and

Statement of Cash
Flows

Revsine/Collins/Johnson/Mittelstaedt: Chapter 4

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, All

 Learning objectives
1. How balance sheet accounts are measured and classified.

2. How balance sheet information is used.

3. Balance sheet terminology and format outside the U.S.

4. How footnotes aid your understanding of the firm’s accounting policies,

subsequent events, and related-party transactions.

5. How successive balance sheet and the income statement can be used
to identify cash inflows and outflows.

6. How the cash flow statements can be used to explain changes in

successive balance sheets.

RCJM: Chapter 4 © 2009 4-2

 Learning objectives
Concluded

7. The distinction between operating, investing, and financing sources and uses of cash.

8. How changes in current asset and current liability accounts can be used to compute
“cash flows from operations” from accrual earnings.

RCJM: Chapter 4 © 2009 4-3

 Elements of the balance sheet
How the money
is invested Where the money came from

ASSETS = LIABILITIES + EQUITY

• Probable future economic benefits

• Obtained from past transactions or events

• Probable future sacrifices of economic benefits

• Arising from present obligations
• To transfer assets or provide services in the future
• As a result of past transactions or events

• The residual interest in net assets.

RCJM: Chapter 4 © 2009 4-4

 Balance sheet information

Rates of return ROA and ROCE

Capital structure Debt vs. Equity

ASSETS
Helps
Liquidity Cash conversion
assess
LIABILITIES
+
Solvency Ability to pay debt
EQUITY

Flexibility Operating and financial

Balance Sheet

RCJM: Chapter 4 © 2009 4-5

 Balance sheet measurement
conventions

Historical cost

ASSETS
Current cost (fair value)
Measurement
methods
LIABILITIES Net realizable value
+
EQUITY
Discounted present value

Balance Sheet

RCJM: Chapter 4 © 2009 4-6

 Balance sheet classification:
Overview

ASSETS = LIABILITIES + EQUITY

• Current assets
• Property, plant and equipment
• Investments
• Current liabilities
• Other assets
• Long-term debt
• Other liabilities

• Preferred and common stock

• Additional paid-in capital
• Retained earnings

RCJM: Chapter 4 © 2009 4-7

 Balance sheet classification:
Current assets

Current market
value

Amortized cost or
current market value

Net realizable value

Lower of (historical) cost

or current market value

RCJM: Chapter 4 © 2009 4-8

 Balance sheet classification:
Other assets

Historical cost minus accumulated depreciation

except that fair market value is used when “impaired”

RCJM: Chapter 4 © 2009 4-9

 Balance sheet classification:
Liabilities

Amount due
at maturity
Historical
cost

Discounted
present value

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 Balance sheet classification:
Stockholders’ equity

Historical
par value

Historical
cost

Mixture of different
measurement bases

RCJM: Chapter 4 © 2009 4-11

 Analytical insights:
Understanding the business

Which company is:

Deere
E-Trade
Potomac
Electric Power
Wal-Mart

RCJM: Chapter 4 © 2009 4-12

 Balance sheet presentation:
International differences

U.S. Format: U.K. Format:

Current Assets Fixed Assets
+ +
Long-lived Assets Current Assets
-
= Current Liabilities
Current Liabilities
-
Non-current Liabilities
+
Non-current Liabilities =
+
Stockholders’ Equity Capital Employed

RCJM: Chapter 4 © 2009 4-13

 Financial statement footnotes
 Footnotes are an integral part of companies’ financial reports.

 These “notes” help users better understand and interpret the

numbers presented in the body of the financial statements.

 Three important notes:

1. Summary of significant accounting policies.
2. Subsequent event disclosures.
3. Related party transactions

RCJM: Chapter 4 © 2009 4-14

 Statement of cash flows
 Explains why a firm’s cash position changed between successive
balance sheet dates. Here’s a balance sheet equation:

Cash + Non-cash assets = Liabilities + Stockholders’ equity

Cash = Liabilities - Non-cash assets + Stockholder’s equity

ΔCash = Δ Liabilities - Δ Non-cash assets + Δ Stockholders’ equity

 At the same time, it explains why non-cash assets, liabilities, and

stockholders’ equity have changed.

RCJM: Chapter 4 © 2009 4-15

 Cash flow statement format

Cash inflows and outflows from

Operating Activities transactions and events that affect
operating income

Cash inflows and outflows from loaning

money to others, investing in securities, or
Investing Activities in assets (e.g., equipment) used to produce
goods and services.

Cash inflows and outflows from

Financing Activities borrowing money, selling stock, and
paying dividends

Δ Cash

RCJM: Chapter 4 © 2009 4-16

 Cash flow statement:
Wal-Mart example

Adjustments to accrual earnings

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 Cash flow statement:
Wal-Mart example

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 Cash flow versus accrual
earnings:
HRB Advertising Company
 Opened for business on April 1, when each partner
contributed $3,500 cash.
 Transactions for the year:

 Profit (accrual earnings) for the year was $3,725 but

the checking account was overdrawn by $11,200

RCJM: Chapter 4 © 2009 4-19

 Here’s what happened at HRB

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 Deriving cash flows from
operations:
Indirect approach

RCJM: Chapter 4 © 2009 4-21

 HRB’s cash flow statement:
Indirect approach

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 Deriving cash flow
information:
HRB one year later

Bank loan
refinanced

Stock issued

RCJM: Chapter 4 © 2009 4-23

 Deriving cash flow
information:
HRB’s accrual earnings and cash flows

RCJM: Chapter 4 © 2009 4-24

 Deriving cash flow
information:
HRB’s accrual earnings and cash flows

RCJM: Chapter 4 © 2009 4-25

 Deriving cash flow
information:
Overview

Income
statement

Beginning Ending
Balance sheet Balance sheet

Cash flow
statement

You can always derive any one financial statement from

information available in the other three statements.

RCJM: Chapter 4 © 2009 4-26

 Deriving cash flow
information:
Cash collected from customers

RCJM: Chapter 4 © 2009 4-27

 Deriving cash flow
information:
Salaries paid

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 Deriving cash flow
information:
Rent paid

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 Deriving cash flow
information:
Utilities paid

RCJM: Chapter 4 © 2009 4-30

 Deriving cash flow
information:
Cash paid for supplies

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 Deriving cash flow
information:
Interest paid

RCJM: Chapter 4 © 2009 4-32

 Deriving cash flow
information:
Office equipment cash flows
Balance Sheet
Office Equipment

$15,000
Purchase
$1,500
(cash basis)
$16,500

Income Statement Accumulated

Depreciation Expenses Depreciation

$2,250

$3,250 3,250

$5,500

accrual basis

RCJM: Chapter 4 © 2009 4-33

 Deriving cash flow
information:
Bank loan and note cash flows

Bank Loan
$10,000
$10,000
$0

Note Refinancing
Payable
$0
$10,000
$10,000

RCJM: Chapter 4 © 2009 4-34

 Deriving cash flow
information:
Common stock and retained earnings

Common Stock
$10,500
Stock issued
$6,000 (cash basis)
$16,500

Retain Earnings
$3,735
Net losses
(accrual basis) $1,725
$2,000

RCJM: Chapter 4 © 2009 4-35

 Deriving cash flow
information:
Cash receipts and disbursements

RCJM: Chapter 4 © 2009 4-36

 Summary

1. The balance sheet shows the assets owned by a company at a

given point in time, and how those assets are financed (debt vs.
equity).

2. Be alert for differences in balance sheet measurement bases,

account titles, and statement format.

3. Financial statement footnotes provide important information.

4. The cash flow statement shows the change in cash for a given
period, broken down into operating, investing, and financing
activities.

RCJM: Chapter 4 © 2009 4-37

 Summary concluded

5. Changes in certain balance sheet accounts help explain why

operating cash flows differ from accrual income.

6. Conversely, the cash flow statement helps to explain changes in

balance sheet accounts

7. T-accounts are a useful analytical device for deriving cash flow

and accrual income information from successive balance sheets

RCJM: Chapter 4 © 2009 4-38