The balance sheet and financial disclosures

1. The balance sheet and financial disclosures Chapter 3 � 2009 The McGraw-Hill Companies, Inc. Chapter 3: The Balance Sheet and Financial Disclosures Chapter 3: The Balance Sheet and Financial Disclosures

2. The Balance Sheet The three primary elements of the balance sheet are assets, liabilities and owners� equity. Let�s look at each of these elements in more detail.The three primary elements of the balance sheet are assets, liabilities and owners� equity. Let�s look at each of these elements in more detail.

3. Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

4. Current Assets Part I Current assets include cash and all other assets expected to become cash or consumed within one year or the operating cycle, whichever is longer. Current assets includes cash, cash equivalents, short-term investments, receivables, inventories, and prepaid expenses. Part II Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. Cash that is restricted for a special purpose and not available for current operations should not be classified as a current asset. Part I Current assets include cash and all other assets expected to become cash or consumed within one year or the operating cycle, whichever is longer. Current assets includes cash, cash equivalents, short-term investments, receivables, inventories, and prepaid expenses. Part II Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. Cash that is restricted for a special purpose and not available for current operations should not be classified as a current asset.

5. Noncurrent Assets Noncurrent assets include investments, property, plant and equipment, intangibles, and other long-term assets. Noncurrent assets are not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer. Noncurrent assets include investments, property, plant and equipment, intangibles, and other long-term assets. Noncurrent assets are not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer.

6. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities as a result of past transactions or events.Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities as a result of past transactions or events.

7. Current Liabilities Current liabilities are expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer. Current liabilities include accounts payable, notes payable, accrued liabilities, and current maturities of long-term debt.Current liabilities are expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer. Current liabilities include accounts payable, notes payable, accrued liabilities, and current maturities of long-term debt.

8. Long-term Liabilities Long-term liabilities are not expected to be satisfied through current assets or creation of current liabilities within one year or the operating cycle, whichever is longer. Long-term liabilities include long-term notes, mortgages, long-term bonds, pension obligations, and lease obligations. Long-term liabilities are not expected to be satisfied through current assets or creation of current liabilities within one year or the operating cycle, whichever is longer. Long-term liabilities include long-term notes, mortgages, long-term bonds, pension obligations, and lease obligations.

9. Shareholders� Equity is the residual interest in the assets of an entity that remains after deducting liabilities. Shareholders� Equity is the residual interest in the assets of an entity that remains after deducting liabilities.

10. Disclosure Notes Part I The full-disclosure principle requires that financial statements provide all material, relevant information concerning the reporting entity. Disclosure notes typically span several pages and either explain or elaborate upon the data presented in the financial statements themselves, or provide information not directly related to any specific item in the statements. Disclosure notes must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions. The summary of significant accounting policies conveys valuable information about the company�s choices from among various alternative accounting methods. For example, management chooses whether to use accelerated or straight-line depreciation and whether to use first-in, first-out; last-in, first-out; or weighted average to measure inventories. Typically, this first disclosure note consists of a summary of significant accounting polices that discloses the choices the company makes. Part II A subsequent event is a significant development that takes place after the company�s fiscal year-end but before the financial statements are issued. Examples include the issuance of debt or equity securities, a business combination or the sale of a business, the sale of assets, an event that sheds light on the outcome of a loss contingency, or any other event having a material effect on operations. Part III Some transactions and events occur only occasionally, but when they do occur are potentially important to evaluating a company�s financial statements. In this category are related party transactions, errors and irregularities, and illegal acts. Part I The full-disclosure principle requires that financial statements provide all material, relevant information concerning the reporting entity. Disclosure notes typically span several pages and either explain or elaborate upon the data presented in the financial statements themselves, or provide information not directly related to any specific item in the statements. Disclosure notes must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions. The summary of significant accounting policies conveys valuable information about the company�s choices from among various alternative accounting methods. For example, management chooses whether to use accelerated or straight-line depreciation and whether to use first-in, first-out; last-in, first-out; or weighted average to measure inventories. Typically, this first disclosure note consists of a summary of significant accounting polices that discloses the choices the company makes. Part II A subsequent event is a significant development that takes place after the company�s fiscal year-end but before the financial statements are issued. Examples include the issuance of debt or equity securities, a business combination or the sale of a business, the sale of assets, an event that sheds light on the outcome of a loss contingency, or any other event having a material effect on operations. Part III Some transactions and events occur only occasionally, but when they do occur are potentially important to evaluating a company�s financial statements. In this category are related party transactions, errors and irregularities, and illegal acts.

11. Auditors� Opinions Part I There are four types of audit opinions. An unqualified opinion is issued when the financial statements present fairly the financial position, results of operations, and cash flows are in conformity with generally accepted accounting principles. Part II A qualified opinion is issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole. Examples of exceptions are nonconformity with generally accepted accounting principles, inadequate disclosures, and a limitation or restriction of the scope of the examination. Part III An adverse opinion is issued when the exceptions are so serious that a qualified opinion is not justified. Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report. Part IV A disclaimer opinion is issued when insufficient information has been gathered to express an opinion. Part I There are four types of audit opinions. An unqualified opinion is issued when the financial statements present fairly the financial position, results of operations, and cash flows are in conformity with generally accepted accounting principles. Part II A qualified opinion is issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole. Examples of exceptions are nonconformity with generally accepted accounting principles, inadequate disclosures, and a limitation or restriction of the scope of the examination. Part III An adverse opinion is issued when the exceptions are so serious that a qualified opinion is not justified. Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report. Part IV A disclaimer opinion is issued when insufficient information has been gathered to express an opinion.

12. Using Financial Statement Information Part I Investors, creditors, and others use information that companies provide in corporate financial reports to make decisions. Comparative financial statements allow financial statement users to compare year-to-year financial position, results of operations, and cash flows. Part II Some analysts enhance their comparison by using horizontal analysis. Horizontal analysis expresses each item in the financial statements as a percentage of that same item in the financial statements of another year (base amount). Part III Similarly, vertical analysis involves expressing each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, but within the same year. For example, cash inventory, and other assets can be restated as a percentage of total assets; net income and each expense can be restated as a percentage of revenues. Part IV No accounting numbers are meaningful in and of themselves. Ratio analysis allows analysts to control for size differences over time and among firms. Part I Investors, creditors, and others use information that companies provide in corporate financial reports to make decisions. Comparative financial statements allow financial statement users to compare year-to-year financial position, results of operations, and cash flows. Part II Some analysts enhance their comparison by using horizontal analysis. Horizontal analysis expresses each item in the financial statements as a percentage of that same item in the financial statements of another year (base amount). Part III Similarly, vertical analysis involves expressing each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, but within the same year. For example, cash inventory, and other assets can be restated as a percentage of total assets; net income and each expense can be restated as a percentage of revenues. Part IV No accounting numbers are meaningful in and of themselves. Ratio analysis allows analysts to control for size differences over time and among firms.

13. Liquidity Ratios Liquidity refers to the readiness of assets to be converted to cash. Liquidity ratios compare a company�s obligations that will shortly become due with the company�s cash and other current assets that, by definition, are expected to be used to pay for the obligations that will be due in the short term. The current ratio is calculated as current assets divided by current liabilities and measures a company�s ability to satisfy its short-term liabilities. A current ratio of 2 indicates that the company has twice as many current assets available as current liabilities. A company could have difficulty paying its liabilities even with a current ratio significantly greater than 1.o. For example, a large portion of the current assets could include inventory. If the inventory is not able to be converted into cash for several months, obligations may come due that could not be paid out of current assets. The acid-test ratio is calculated as quick assets divided by current liabilities. Quick assets are current assets excluding inventories and prepaid items. By eliminating current assets less readily convertible into cash, this ratio provides a more stringent indication of a company�s ability to pay its current liabilities. Liquidity refers to the readiness of assets to be converted to cash. Liquidity ratios compare a company�s obligations that will shortly become due with the company�s cash and other current assets that, by definition, are expected to be used to pay for the obligations that will be due in the short term. The current ratio is calculated as current assets divided by current liabilities and measures a company�s ability to satisfy its short-term liabilities. A current ratio of 2 indicates that the company has twice as many current assets available as current liabilities. A company could have difficulty paying its liabilities even with a current ratio significantly greater than 1.o. For example, a large portion of the current assets could include inventory. If the inventory is not able to be converted into cash for several months, obligations may come due that could not be paid out of current assets. The acid-test ratio is calculated as quick assets divided by current liabilities. Quick assets are current assets excluding inventories and prepaid items. By eliminating current assets less readily convertible into cash, this ratio provides a more stringent indication of a company�s ability to pay its current liabilities.

14. Financing Ratios Investors and creditors, particularly long-term creditors, are vitally interested in a company�s long-term solvency and stability. The debt to equity ratio is calculated as total liabilities divided by shareholders� equity. This ratio indicates the extent of reliance on creditors, rather than owners, in providing resources. The higher this ratio, the greater the creditor claims on assets, so the higher the likelihood an individual creditor would not be paid in full if the company is unable to meet its obligations. The times interest earned ratio is a way to gauge the ability of a company to satisfy its fixed debt obligations by comparing interest charges with the income available to pay those charges. This ratio is calculated as net income plus interest expense plus taxes divided by interest expense. The times interest earned ratio indicates the margin of safety provided to creditors. Investors and creditors, particularly long-term creditors, are vitally interested in a company�s long-term solvency and stability. The debt to equity ratio is calculated as total liabilities divided by shareholders� equity. This ratio indicates the extent of reliance on creditors, rather than owners, in providing resources. The higher this ratio, the greater the creditor claims on assets, so the higher the likelihood an individual creditor would not be paid in full if the company is unable to meet its obligations. The times interest earned ratio is a way to gauge the ability of a company to satisfy its fixed debt obligations by comparing interest charges with the income available to pay those charges. This ratio is calculated as net income plus interest expense plus taxes divided by interest expense. The times interest earned ratio indicates the margin of safety provided to creditors.

15. End of Chapter 3 � 2008 The McGraw-Hill Companies, Inc. End of Chapter 3. End of Chapter 3.