Chapter 5 The balance sheet and statement of cash flowsSommers – Intermediate I
The Balance Sheet Reports a company’s financial position on a particular date. Limitations: The balance sheet does not directly measure the market value of the entity nor its liquidation value, but it provides valuable information that can be used to help judge market value. Resources such as employee skills and reputation are not recorded in the balance sheet. Usefulness: The balance sheet describes many of the resources a company has for generating future cash flows. It provides liquidity information useful in assessing a company’s ability to pay its current obligations. It provides long-term solvency information relating to the riskiness of a company with regard to the amount of liabilities in its capital structure.
Discussion Question Q5-2 What is meant by solvency? What information in the balance sheet can be used to assess a company’s solvency?
Balance Sheet Classification Classification Illustration 5-1 In practice you usually see little departure from these major subdivisions.
Classification in the Balance Sheet Current Assets Cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer. Illustration 5-2
Balance Sheet – Current Assets Current Assets - “Summary” Cash and other assets a company expects to convert into cash, sell, or consume either in one yearor in the operating cycle, whichever is longer.
Balance Sheet – Current Assets Cash Generally any monies available “on demand.” Cash equivalents - short-term highly liquid investments that mature within three months or less. Restrictions or commitments must be disclosed. Illustration 5-3
Balance Sheet – Current Assets Short-Term and Long-Term Investments Portfolios Type Valuation Classification Held-to-Maturity Debt Amortized Cost Current or Noncurrent Trading Debt or Equity Fair Value Current Adj on Inc Stmt Available- for-Sale Debt or Equity Fair Value Current or Noncurrent Adj is OCI
Balance Sheet – Current Assets Receivables Major categories of receivables should be shown in the balance sheet or the related notes.A company should clearly identify Anticipated loss due to uncollectibles. Amount and nature of any nontrade receivables. Receivables used as collateral.
Balance Sheet – Current Assets Inventories Disclose: Basis of valuation (e.g., lower-of-cost-or-market). Cost flow assumption (e.g., FIFO or average cost). Illustration 5-6
Classification in the Balance Sheet Non-Current Assets Long-term Investments Securities (bonds, common stock, or long-term notes). Tangible fixed assets not currently used in operations (land held for speculation). Special funds (sinking fund, pension fund, or plant expansion fund). Non-consolidated subsidiaries or affiliated companies.
Balance Sheet – Noncurrent Assets Long-Term Investments Securities bonds, stock, and long-term notes For marketable securities, management’s intent determines current or noncurrent classification.
Balance Sheet – Noncurrent Assets Long-Term Investments Fixed Assets Land held for speculation
Balance Sheet – Noncurrent Assets Long-Term Investments Special Funds Sinking fund Pensions fund Cash surrender value of life insurance
Balance Sheet – Noncurrent Assets Property, Plant, and Equipment Tangible long-lived assets used in the regular operations of the business. Physical property such as land, buildings, machinery, furniture, tools, and wasting resources (minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., oil reserves) these assets.
Balance Sheet – Noncurrent Assets Property, Plant, and Equipment Tangible assets used in the regular operations of the business.
Balance Sheet – Noncurrent Assets Illustration 5-11 Balance Sheet Presentation of Property, Plant, and Equipment
Balance Sheet – Noncurrent Assets Intangibles Lack physical substance and are not financial instruments. Limited life intangibles amortized. Indefinite-life intangibles tested for impairment.
Balance Sheet – Noncurrent Assets Other Assets Items vary in practice. Can include: Long-term prepaid expenses Non-current receivables Assets in special funds Property held for sale Restricted cash or securities
Balance Sheet – Noncurrent Assets Other Assets This section should include only unusual items sufficiently different from assets in the other categories.
Classification in the Balance Sheet Current Liabilities “Obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities.”
Classification in the Balance Sheet Current Liabilities Illustration 5-13 Balance Sheet Presentation of Current Liabilities
Classification in the Balance Sheet Long-Term Liabilities “Obligations that a company does not reasonably expect to liquidate within the normal operating cycle.” All covenants and restrictions must be disclosed.
Balance Sheet Format Classified Report Form Illustration 5-16
Discussion Question Q5-4 Discuss at least two situations in which estimates could affect the usefulness of information in the balance sheet.
E5-1 Balance Sheet Classification Investment in Preferred Stock Treasury Stock Common Stock Dividends Payable Accumulated Depreciation – Equipment Construction in Process Petty Cash Interest Payable Deficit Equity Investments (trading) Income Tax Payable Unearned Subscription Revenue Work in Process Vacation Wages Payable
Ratio Analysis Categories Liquidity – Measures of the company’s short-term ability to pay its maturing obligations. Activity – Measures of how effectively the company uses its assets. Profitability – Measures of the degree of success or failure of a given company or division for a given period of time. Coverage – Measures of the degree of protection for long-term creditors and investors.
For Exam (p. 246)
Calculating Ratios Current cash debt coverage ratio Inventory turnover Profit margin on sales Debt to total assets
Calculating Ratios Big Lots Current cash debt coverage ratio Inventory turnover Profit margin on sales Debt to total assets Family Dollar 0.52 5.05 4.54% 0.64
Word(s) of the Day for Cash Flows
Statement of Cash Flows Purpose of the Statement of Cash Flows To provide relevant information about the cash receipts and cash payments of an enterprise during a period. The statement provides answers to the following questions: Where did the cash come from? What was the cash used for? What was the change in the cash balance?
Focus on Perhaps the most noteworthy item reported on an income statement is net income—the amount by which revenues exceed expenses. The most noteworthy item reported on a statement of cash flows is not the amount of net cash flows. The amount of net cash flows may in fact be the least important number on the statement. The increase or decrease in cash can be seen easily on comparative balance sheets. The purpose of the Statement of Cash Flows is not to report that cash increased or decreased by a certain amount, but why cash increased or decreased by that amount. The individual cash inflows and outflows provide that information.
Discussion Question Q5-24 Differentiate between operating activities, investing activities, and financing activities.
Classification of Cash Flows Balance Sheet Current Assets Current Liabilities Operating Noncurrent Liabilities Noncurrent Assets Investing Financing Equity
Classifying Cash Flows Indicate the reporting classification of each transaction by entering the appropriate classification code. +I Investing activity (cash inflow) –I Investing activity (cash outflow) +F Financing activity (cash inflow) –F Financing activity (cash outflow) N Noncash investing and financing activity X Not reported as an investing and/or a financing activity Sale of land Issuance of common stock for cash Purchase of treasury stock Conversion of bonds payable to common stock Lease of equipment by capital lease Sale of patent
Classifying Cash Flows +I Investing activity (cash inflow) –I Investing activity (cash outflow) +F Financing activity (cash inflow) –F Financing activity (cash outflow) N Noncash investing and financing activity X Not reported as an investing and/or a financing activity Acquisition of building for cash Issuance of common stock for land Collection of note receivable (principal amount) Issuance of bonds Payment of cash dividends Issuance of short-term note payable for cash Issuance of long-term note payable for cash Purchase of marketable securities (“available for sale”)
Classifying Cash Flows +I Investing activity (cash inflow) –I Investing activity (cash outflow) +F Financing activity (cash inflow) –F Financing activity (cash outflow) N Noncash investing and financing activity X Not reported as an investing and/or a financing activity Payment of note payable Sale of equipment Issuance of note payable for equipment Repayment of long-term debt by issuing common stock Loan to another firm Sale of inventory to customers Purchase of marketable securities (cash equivalents)
Direct Method Indirect Method Reports the cash effects of each operating activity Starts with accrualnet income and converts to cash basis Reporting Cash Flows from Operating Activities Two Formats for Reporting Operating Activities Note that no matter which format is used, the same amount of net cash flows operating activities is generated.
Direct Method Under the direct method, the cash effect of each operating activity is reported directly in the statement.
Indirect Method By the indirect method, we arrive at net cash flow from operating activities indirectly by starting with reported net income and working backwards to convert that amount to a cash basis.
Noncash Investing and Financing Activities Significant investing and financing transactions not involving cash also are reported (usually in a disclosure note). Acquiring an asset by incurring a debt payable to the seller. Acquiring an asset by entering into a capital lease. Converting debt into common stock or other equity securities. Exchanging noncash assets or liabilities for other noncash assets or liabilities.
Determining Cash Received or Paid When preparing a SCF using direct method, the numbers needed generally are not kept by the accounting system There is not an account that is the amount (balance) of cash paid to suppliers for merchandise Most people get these numbers by backing into them using accounting relations via T-accounts or by using journal entries
Determining Cash Received or Paid Given: Beginning End of yearof year Inventory $ 90 $ 93 Accounts payable 14 16 Cost of goods sold 300 Determine cash paid to merchandise suppliers. Cash paid to suppliers for merchandise
Cash from Customers Given: Beginning End of yearof year Accounts receivable $ 100 $110 Allowance for bad debts 5 3 Sales revenue 600 Bad debt expense 10 Determine cash received from customers. Cash received from customers
Proceeds from Sale On July 15, 2011, M.W. Morgan Distribution sold land for $35 million that it had purchased in 2006 for $22 million. What would be the amount(s) related to the sale that Morgan would report in its statement of cash flows for the year ended December 31, 2011, using the direct method? The indirect method? Cash 35 Land (cost) 22 Gain on sale of land (difference) 13 Morgan would report the cash inflow of $35 million from the sale as a cash inflow from investing activities in its statement of cash flows. The $13 million gain is not a cash flow and would not be reported when using the direct method. When using the indirect method, the gain would be subtracted from net income (which includes the gain) to avoid double-counting it.
Red, Inc. Cash Flow Problem
Red, Inc. Cash Flow Problem
Red, Inc. Statement of Cash Flows For year ended December 31, 2011 Cash flows from operating activities:
Red, Inc. Statement of Cash Flows For year ended December 31, 2011 Cash flows from investing activities: Cash flows from financing activities: Net increase in cash (86) Cash balance, January 1 110 Cash balance, December 31 $ 24
IFRS RELEVANT FACTS Both IFRS and GAAP allow the use of title “balance sheet” or “statement of financial position.” IFRS recommends but does not require the use of the title “statement of financial position” rather than balance sheet. Both IFRS and GAAP require disclosures about (1) accounting policies followed, (2) judgments that management has made in the process of applying the entity’s accounting policies, and (3) the key assumptions and estimation uncertainty that could result in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. Comparative prior period information must be presented and financial statements must be prepared annually. IFRS and GAAP require presentation of noncontrolling interests in the equity section of the balance sheet.
IFRS RELEVANT FACTS IFRS requires a classified statement of financial position except in very limited situations. IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities. However under GAAP, public companies must follow SEC regulations, which require specific line items. Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last. IFRS has many differences in terminology. For example in the equity section common stock is called share capital—ordinary. Use of the term “reserve” is discouraged in GAAP, but there is no such prohibition in IFRS.