Powerpoint

UNDERSTANDING FINANCIAL UNDERSTANDING FINANCIAL STATEMENTSSTATEMENTS

THE BALANCE SHEETTHE BALANCE SHEET

What is a BALANCE SHEET?What is a BALANCE SHEET?

A “statement of financial condition”A “statement of financial condition”

On a particular date (a “snapshot”)On a particular date (a “snapshot”)

OBJECTIVES:OBJECTIVES:– a fundamental understanding of accounts a fundamental understanding of accounts

described on a balance sheetdescribed on a balance sheet– a feel for the relationship of each account to a feel for the relationship of each account to

the financial statements as a wholethe financial statements as a whole

The Basic EquationThe Basic Equation

ASSETS = LIABLITIES + ASSETS = LIABLITIES + STOCKHOLDERS’ EQUITYSTOCKHOLDERS’ EQUITY

– Where assets are economic resources (the Where assets are economic resources (the left side of the equation)left side of the equation)

– Where liabilities and equities are claims to Where liabilities and equities are claims to those resources (the right side of the those resources (the right side of the equation)equation)

Another look: Basic EquationAnother look: Basic Equation

ASSETS are what the firm ASSETS are what the firm ownsowns

LIABILITIES are what the firm LIABILITIES are what the firm owesowes to to outsidersoutsiders

EQUITIES are what the firm EQUITIES are what the firm owesowes to to insidersinsiders

Therefore: Assets = Liabilities + Therefore: Assets = Liabilities + Stockholders’ Equity represents equality Stockholders’ Equity represents equality between resources and claims to resourcesbetween resources and claims to resources

Classify each accountClassify each account

Salary ExpenseSalary ExpenseSalesSalesLandLandAccounts PayableAccounts PayableAccounts RecAccounts RecEquipmentEquipmentCashCashNotes payableNotes payablePrepaid insurancePrepaid insurance

SuppliesSuppliesSupply ExpenseSupply ExpenseAccumulated Accumulated DepreciationDepreciationDepreciation expenseDepreciation expenseCommon StockCommon StockRetained EarningsRetained EarningsPatentPatent

Some General ParametersSome General Parameters

Financial statements are often Financial statements are often CONSOLIDATEDCONSOLIDATED

Balance sheet is DATED (end of Balance sheet is DATED (end of accounting period): calendar year or fiscal accounting period): calendar year or fiscal year or interim periodyear or interim period

Some COMPARATIVE DATA is presented Some COMPARATIVE DATA is presented (e.g. balances for end of previous year (e.g. balances for end of previous year shown on balance sheet) shown on balance sheet)

ASSETS (the “left” side)ASSETS (the “left” side)

Generally presented in order of liquidityGenerally presented in order of liquidity

Current Assets -- defined as cash or Current Assets -- defined as cash or assets expected to be converted to cash assets expected to be converted to cash within one year or operating cycle, within one year or operating cycle, whichever is longerwhichever is longer– operating cycle is time required to operating cycle is time required to

purchase/manufacture the inventory, sell it purchase/manufacture the inventory, sell it and collect the cashand collect the cash

ASSETS (continued)ASSETS (continued)

Noncurrent Assets -- defined as assets Noncurrent Assets -- defined as assets expected to be converted to cash after the expected to be converted to cash after the completion of one year or one operating completion of one year or one operating cycle, whichever is longer cycle, whichever is longer

A Look at Current AssetsA Look at Current Assets

CashCash

Marketable Securities (short-term)Marketable Securities (short-term)

Accounts ReceivableAccounts Receivable

Notes Receivable (short-term)Notes Receivable (short-term)

InventoryInventory

Prepaid ExpensesPrepaid Expenses

...and Noncurrent Assets?...and Noncurrent Assets?

Long-term InvestmentsLong-term Investments

Property, Plant and EquipmentProperty, Plant and Equipment

Intangible AssetsIntangible Assets

““Other” Assets -- the “catchall” categoryOther” Assets -- the “catchall” category

Okay, let’s go one-by-one:Okay, let’s go one-by-one:

First we’ll look at typical current assetsFirst we’ll look at typical current assets

Then we’ll turn our attention to typical Then we’ll turn our attention to typical noncurrent assetsnoncurrent assets– Later we’ll look at liabilities and equities (the Later we’ll look at liabilities and equities (the

“right” side of the equation)“right” side of the equation)

Objective is to understand what the Objective is to understand what the category is and what the numbers mean category is and what the numbers mean (sometimes this is easy, then (sometimes this is easy, then sometimes….)sometimes….)

CashCash

The most liquid of assetsThe most liquid of assets

Generally includes currency, coin, Generally includes currency, coin, balances in checking and other demand or balances in checking and other demand or “near demand” accounts“near demand” accounts

Marketable SecuritiesMarketable Securities

May include t-bills, CDs, stocks, bondsMay include t-bills, CDs, stocks, bonds

Debt vs. equity securitiesDebt vs. equity securities

ClassificationsClassifications– Held to maturityHeld to maturity– Trading securitiesTrading securities– Securities available for saleSecurities available for sale

Investment CategoryInvestment Category Held to Held to maturitymaturity

TradingTrading Avail for SaleAvail for Sale

TypeType DebtDebt Debt & EqDebt & Eq Debt & EqDebt & Eq

RevenueRevenue InterestInterest Int & DivInt & Div Int & DivInt & Div

Value on BSValue on BS Amortized Amortized CostCost

Market Market ValueValue

Market ValueMarket Value

Recog Unreal G/L on Recog Unreal G/L on IS?IS?

NoNo YesYes No (unrealized No (unrealized g/l in equity sec)g/l in equity sec)

Cash FlowCash Flow InvestingInvesting OperatingOperating InvestingInvesting

DescriptionDescription Intent and Intent and ability to ability to hold until hold until maturitymaturity

Traded Traded within 3 within 3 monthmonth

Not in other Not in other categoriescategories

The following events apply to the investment activities of The following events apply to the investment activities of Duffy Company.Duffy Company.

1.1. Duffy purchased $25,000 of debt securities on January 1, Duffy purchased $25,000 of debt securities on January 1, 20X1.20X1.

2.2. Duffy sold $5,000 of the debt securities purchased in Duffy sold $5,000 of the debt securities purchased in Event No. 1 for $6,000.Event No. 1 for $6,000.

3.3. Duffy received $2,000 of interest income on December Duffy received $2,000 of interest income on December 31, 20X1.31, 20X1.

4.4. The market value of the remaining debt securities was The market value of the remaining debt securities was $20,500 on December 31, 20X1.$20,500 on December 31, 20X1.

Required:Required:

Record the effects of each event in a financial statements Record the effects of each event in a financial statements model assuming the debt securities are classified as (1) model assuming the debt securities are classified as (1) held-to-maturity, (2) trading, or (3) available-for-sale. held-to-maturity, (2) trading, or (3) available-for-sale. When recording amounts in the cash flow column, When recording amounts in the cash flow column, indicate whether the item is an operating activity (OA), indicate whether the item is an operating activity (OA), investing activity (IA) or a financing activity (FA).investing activity (IA) or a financing activity (FA).

SolutionSolution

Click here to download solutionClick here to download solution

Solution is labeled Demo Problem 8-1Solution is labeled Demo Problem 8-1

You probably want to go ahead and print it You probably want to go ahead and print it off because there is another solution on off because there is another solution on the page for a problem on inventory.the page for a problem on inventory.

Accounts ReceivableAccounts Receivable

Arise from credit-sale transactionsArise from credit-sale transactions

Reported on the balance sheet at NET Reported on the balance sheet at NET REALIZABLE VALUEREALIZABLE VALUE– Accounts ReceivableAccounts Receivable $$$ $$$– Less Allowance for Doubtful Accounts Less Allowance for Doubtful Accounts $$$$$$– Net Accounts ReceivableNet Accounts Receivable $$$ $$$

A Word on the “Allowance…”A Word on the “Allowance…”

Management must estimate the dollar Management must estimate the dollar amount of accounts they expect to be amount of accounts they expect to be uncollectibleuncollectible

Affects balance sheet valuation AND bad Affects balance sheet valuation AND bad debt expense on income statementdebt expense on income statement

Can be important in assessing earnings Can be important in assessing earnings quality -- changes should be analyzedquality -- changes should be analyzed

Analyzing receivables - KodakAnalyzing receivables - Kodak

20002000 19991999

Trade receivablesTrade receivables $2,245$2,245 $2,140$2,140

Miscellaneous recMiscellaneous rec 408408 397397

Total (net of allowances of 89 and Total (net of allowances of 89 and 136)136)

$2,653$2,653 $2,537$2,537

20002000 19991999

Receivables (from balance sheet)Receivables (from balance sheet) $2,653$2,653 $2,537$2,537

Allowance (Note 20Allowance (Note 20 8989 136136

Total ReceivablesTotal Receivables $2,742$2,742 $2,673$2,673

Sales (from income statementSales (from income statement 13,99413,994 14,08914,089

InventoryInventory

Consist of items held for sale or used in Consist of items held for sale or used in manufacture of goods for salemanufacture of goods for sale

Merchandising CompanyMerchandising Company– one type of inventory (finished goods)one type of inventory (finished goods)

Manufacturing CompanyManufacturing Company– three types of inventories (raw materials, work-in-three types of inventories (raw materials, work-in-

process, finished goods)process, finished goods)

Often a BIG dollar item -- often firm’s major Often a BIG dollar item -- often firm’s major revenue producerrevenue producer

Inventory IssuesInventory Issues

Major concern with method of valuation Major concern with method of valuation (which MUST be DISCLOSED)(which MUST be DISCLOSED)– FIFO (first-in, first-out)FIFO (first-in, first-out)– LIFO (last-in, first-out)LIFO (last-in, first-out)– Weighted Average Cost Weighted Average Cost

Effect of inflation on CGS and NIEffect of inflation on CGS and NI

Illustration of Fifo/LifoIllustration of Fifo/Lifo

1/11/1 BIBI 200@$3200@$3 $600$6003/1 Purchase 3/1 Purchase 300@$3.50300@$3.50 105010506/1 Purchase 400 @ $4.006/1 Purchase 400 @ $4.00 1600160011/1 purchase 100 @ $4.5011/1 purchase 100 @ $4.50 450 450

Total CGAS (1000 units)Total CGAS (1000 units) $3700$3700

Sold 700 unitsSold 700 units

Had 1000 units available for sale, sold 700, so must have 300 left in Had 1000 units available for sale, sold 700, so must have 300 left in ending inventory. For FIFO, the ending inventory will be the last 300 ending inventory. For FIFO, the ending inventory will be the last 300

units in (since first units were sold). For LIFO, the ending inventory will units in (since first units were sold). For LIFO, the ending inventory will be the first 300 units in (since the last ones in were sold)be the first 300 units in (since the last ones in were sold)

FIFOFIFO LIFOLIFO Weighted Weighted AverageAverage

Cost of Goods Cost of Goods Available for Available for SaleSale

$3700$3700 $3700$3700 $3700$3700

Less Ending Less Ending InventoryInventory

[email protected]@4.50


$1250$1250



$950$950

$3700/1000 =$3700/1000 =

$3.70 per unit$3.70 per unit


$1110$1110

Cost of Goods Cost of Goods SoldSold

$2450$2450




$2650$2650




$2590$2590


More Inventory IssuesMore Inventory Issues

Inventory valuations SIGNIFICANTLY Inventory valuations SIGNIFICANTLY affects BOTH the balance sheet and the affects BOTH the balance sheet and the income statementincome statement

Disclosure of inventory cost flow Disclosure of inventory cost flow assumption found on face of balance assumption found on face of balance sheet or (more commonly) in notessheet or (more commonly) in notes

Inventory reported on balance sheet at Inventory reported on balance sheet at LOWER OF COST OR MARKETLOWER OF COST OR MARKET

Pleasant Grove Electronics carries four different types of Pleasant Grove Electronics carries four different types of calculators. The quantities, costs, and market values are calculators. The quantities, costs, and market values are shown below. Based on this information, determine the shown below. Based on this information, determine the amount of the required amount of the required lower of cost or marketlower of cost or market (LCM) write- (LCM) write-down assuming Pleasant Grove determines LCM on an down assuming Pleasant Grove determines LCM on an individual basis. (solution is 8-4 on page you printed)individual basis. (solution is 8-4 on page you printed)

TypeType QuantityQuantity Unit CostUnit Cost Unit MktUnit Mkt

AA 100100 $12$12 1515

BB 550550 88 66

CC 710710 2525 2424

DD 240240 2020 2222

Kodak - inventoriesKodak - inventories

(in millions)(in millions) 20002000 19991999

Sales (from Sales (from income statementincome statement

$13,994$13,994 $14,089$14,089

InventoriesInventories 1,7181,718 1,5191,519

Prepaid ExpensesPrepaid Expenses

Represent expenses paid in advance -- Represent expenses paid in advance -- included in current assets if they expire included in current assets if they expire within one year or operating cyclewithin one year or operating cycle

Usually not a material itemUsually not a material item

Present few or no reporting or valuation Present few or no reporting or valuation issuesissues

ON TO NONCURRENT ASSETS…….ON TO NONCURRENT ASSETS…….

Property, Plant & Equipment Property, Plant & Equipment (PP&E)(PP&E)

Often called “fixed assets”Often called “fixed assets”

Represent major resource commitments Represent major resource commitments which benefit a firm for more than one which benefit a firm for more than one yearyear

Recorded at HISTORICAL cost; cost Recorded at HISTORICAL cost; cost allocated over asset’s useful life through allocated over asset’s useful life through DEPRECIATION (exception: land is not DEPRECIATION (exception: land is not depreciated)depreciated)

PP&E IssuesPP&E Issues

PP&E is reported on balance sheet at PP&E is reported on balance sheet at historical cost less accumulated historical cost less accumulated depreciation to datedepreciation to date

Depreciation process involves Depreciation process involves ESTIMATESESTIMATES

Depreciated cost reported on balance Depreciated cost reported on balance sheet is sheet is reliablereliable; one might seriously ; one might seriously question how question how relevantrelevant it is... it is...

More PP&E IssuesMore PP&E Issues

Firm has CHOICE of depreciation method: Firm has CHOICE of depreciation method: accelerated, straight-lineaccelerated, straight-line

Comparison among firms can be made difficult Comparison among firms can be made difficult with different methods and different estimateswith different methods and different estimates

Use of EBITDAUse of EBITDA

Proportion of fixed assets (PP&E) in a firm’s Proportion of fixed assets (PP&E) in a firm’s asset structure determined by nature of the asset structure determined by nature of the businessbusiness

Depreciation MethodsDepreciation Methods

Straight Line (78%)Straight Line (78%)

Cost – Salvage ValueCost – Salvage Value

Useful LifeUseful Life

Depreciation Expense (IS)Depreciation Expense (IS)

Accumulated Depreciation (BS)Accumulated Depreciation (BS)

Units of Production Method is similar but uses Units of Production Method is similar but uses units of activity as denominatorunits of activity as denominator

ExampleExample

Jones Brothers purchases new equipment for $50,000. Jones Brothers purchases new equipment for $50,000. It is estimated to have a useful life of 5 years and a It is estimated to have a useful life of 5 years and a salvage value of $10,000. How much is the annual salvage value of $10,000. How much is the annual depreciation?depreciation?

50,000-10,000 50,000-10,000 = $40,000/5 = $8,000 per year= $40,000/5 = $8,000 per year

5 years5 years

Year 1 $8,000 dep exp, $42,000 net asset valueYear 1 $8,000 dep exp, $42,000 net asset value

Year 2 $8,000 dep exp, $34,000 net asset value…..Year 2 $8,000 dep exp, $34,000 net asset value…..

Year 5 $8,000 dep exp, $10,000 net asset valueYear 5 $8,000 dep exp, $10,000 net asset value

Depreciation MethodsDepreciation Methods

Accelerated Methods (4%)Accelerated Methods (4%)

Declining balance rateDeclining balance rate

Considered accelerated methodConsidered accelerated method

Year

Depreciation

Expense

Accelerated method

Straight line

Intangible AssetsIntangible Assets

Resources with expected future economic Resources with expected future economic benefits but lacking a physical substancebenefits but lacking a physical substance

Some examples are patents, copyrights, Some examples are patents, copyrights, goodwillgoodwill

Goodwill can be material if firm is heavily Goodwill can be material if firm is heavily involved in acquisition activityinvolved in acquisition activity

Amortization for cost recoveryAmortization for cost recovery– Shorter of economic life, legal life or 40 yearsShorter of economic life, legal life or 40 years

Patent – right to manufacture, Patent – right to manufacture, sell, lease inventionsell, lease invention

Legal life is 17 years Legal life is 17 years from date patent is from date patent is gratedgrated

Copyright – protection against Copyright – protection against illegal reproductions of illegal reproductions of creator’s written works, creator’s written works, designs, and literary designs, and literary productionsproductions

Legal life is life of Legal life is life of creator plus 50 yearscreator plus 50 years

Franchise – contract between Franchise – contract between 2 parties granting franchisee 2 parties granting franchisee certain rights and privilegescertain rights and privileges

(life defined by contract_(life defined by contract_

If lump sum made, If lump sum made, rather than periodic rather than periodic payments, capitalize payments, capitalize and amortizeand amortize

Trademark – symbol, design, Trademark – symbol, design, logo logo

(unlimited legal life)(unlimited legal life)

If internally If internally developed, no cost developed, no cost assignedassigned

GoodwillGoodwill

Prior to FASB 142Prior to FASB 142– Pooling (no goodwill recognized)Pooling (no goodwill recognized)– Purchase (goodwill shown and amortized/40 yr)Purchase (goodwill shown and amortized/40 yr)

1/1/02 FAS 142 1/1/02 FAS 142 – Pooling eliminatedPooling eliminated– Goodwill evaluated annually to determine if it Goodwill evaluated annually to determine if it

has lost value has lost value

Intel Intel

Natural ResourcesNatural Resources

Standing timber and underground deposits Standing timber and underground deposits of oil, gas, and mineralsof oil, gas, and minerals– Physically extracted in operationsPhysically extracted in operations– Replaceable only by an act of natureReplaceable only by an act of nature

Total cost minus salvageTotal cost minus salvageTotal estimated unitsTotal estimated units

Depletion expense (IS)Depletion expense (IS)Accumulated depletion (BS)Accumulated depletion (BS)

Other AssetsOther Assets

Can include multitude of other noncurrent Can include multitude of other noncurrent items, for exampleitems, for example– property held for saleproperty held for sale– long-term investmentslong-term investments– start-up costs in connection with a new start-up costs in connection with a new

business business – cash surrender value of life insurance policiescash surrender value of life insurance policies– long term advance paymentslong term advance payments

NOW WHAT????NOW WHAT????

NOW, HOW ABOUT THE OTHER NOW, HOW ABOUT THE OTHER (“RIGHT”) SIDE OF THE BALANCE (“RIGHT”) SIDE OF THE BALANCE SHEET…….SHEET…….

Let’s take a look at liabilities and equities Let’s take a look at liabilities and equities (the “claims” to the assets we just looked (the “claims” to the assets we just looked at…)at…)

LIABILITIES & EQUITIESLIABILITIES & EQUITIES

REPRESENT CLAIMS TO ASSETSREPRESENT CLAIMS TO ASSETS

LIABILITIES:LIABILITIES: Creditor Claims Creditor Claims

EQUITIES:EQUITIES: Owner Claims Owner Claims

Constitute the “right” side of equationConstitute the “right” side of equation

LIABILITIESLIABILITIES

May be CURRENT or LONG-TERM -- May be CURRENT or LONG-TERM -- same criteria of “one-year or operating same criteria of “one-year or operating cycle, whichever is longer” applies here as cycle, whichever is longer” applies here as wellwell

Represent claims by creditors of the firmRepresent claims by creditors of the firm

A Look at Current LiabilitiesA Look at Current Liabilities

Accounts PayableAccounts Payable

Short-term Notes PayableShort-term Notes Payable

Accrued LiabilitiesAccrued Liabilities

Unearned Revenues (Deferred Credits)Unearned Revenues (Deferred Credits)

Current Maturity Portion of Long-term Current Maturity Portion of Long-term DebtDebt

Deferred Taxes (some, not all or even Deferred Taxes (some, not all or even most…)most…)

……and Long-Term Liabilities?and Long-Term Liabilities?

Notes or Mortgages PayablesNotes or Mortgages Payables

Bonds PayableBonds Payable

Pension and Lease ObligationsPension and Lease Obligations

Deferred Taxes (most)Deferred Taxes (most)

Warranty ObligationsWarranty Obligations

Other Long-Term DebtOther Long-Term Debt

Okay, let’s look at some of Okay, let’s look at some of these…..starting with Current Liabilitiesthese…..starting with Current Liabilities

Accounts PayableAccounts Payable

Usually defined as obligations arising from Usually defined as obligations arising from purchases of merchandise for resale or of purchases of merchandise for resale or of raw materialsraw materials

Few valuation or reporting issuesFew valuation or reporting issues

Significant changes from period to period Significant changes from period to period often result from changes in sales volumeoften result from changes in sales volume

Short-Term Notes PayableShort-Term Notes Payable

Promissory notes due within a year (or Promissory notes due within a year (or operating cycle if more appropriate)operating cycle if more appropriate)

Usually are interest-bearingUsually are interest-bearing

Usually reported at face value because of Usually reported at face value because of short-term natureshort-term nature

Accrued LiabilitiesAccrued Liabilities

Result from accrual basis of accountingResult from accrual basis of accounting

Represent expenses that have been Represent expenses that have been INCURRED and thus ACCRUED, but have INCURRED and thus ACCRUED, but have NOT BEEN PAID in cashNOT BEEN PAID in cash

Examples are Interest Payable and Wages Examples are Interest Payable and Wages PayablePayable

In this case, cash flow In this case, cash flow followsfollows expense expense recognitionrecognition

Unearned RevenueUnearned Revenue

Sometimes called “deferred credits”Sometimes called “deferred credits”

Results from a prepayment received in Results from a prepayment received in advance for services or productsadvance for services or products

Under accrual accounting, revenue is Under accrual accounting, revenue is recognized when EARNED, not when recognized when EARNED, not when received in cash -- in this case, cash flow received in cash -- in this case, cash flow precedesprecedes revenue recognition revenue recognition

Current Maturities - LT DebtCurrent Maturities - LT Debt

Represent principal payments on debt that Represent principal payments on debt that are due within one yearare due within one year

Confirms the old adage that nothing is Confirms the old adage that nothing is long-term forever -- eventually it has to be long-term forever -- eventually it has to be paid as a current item!paid as a current item!

Now, how about those items that are Now, how about those items that are STILL LONG-TERM LIABILITIESSTILL LONG-TERM LIABILITIES

Notes or Mortgages PayableNotes or Mortgages Payable

Represent any mortgages or notes Represent any mortgages or notes payable that do not have any principal payable that do not have any principal repayment requirements during the repayment requirements during the coming yearcoming year

Bonds PayableBonds Payable

Once again, represent items that do not Once again, represent items that do not have any principal payment requirements have any principal payment requirements within the next yearwithin the next year

Bond characteristicsBond characteristics

Secured v. unsecuredSecured v. unsecured

Registered v. bearerRegistered v. bearer

Coupon bondsCoupon bonds

Term v. serialTerm v. serial

CallableCallable

ConvertibleConvertible

Junk bondsJunk bonds

Bond with stock warrantsBond with stock warrants

Pension & Lease ObligationsPension & Lease Obligations

Generally reported at the present value of Generally reported at the present value of expected future cash outflowsexpected future cash outflows

Can represent MAJOR liabilities for many Can represent MAJOR liabilities for many firms and have a significant impact on the firms and have a significant impact on the balance sheetbalance sheet

Defined benefit vs. defined contributionDefined benefit vs. defined contribution

Warranty ObligationsWarranty Obligations

Represent liability of a firm to repair or Represent liability of a firm to repair or replace merchandise that it sells replace merchandise that it sells

Some estimating is necessary, but if the Some estimating is necessary, but if the firm regularly sells items with a warranty firm regularly sells items with a warranty attached, the liability must be disclosed...attached, the liability must be disclosed...

Postemployment LiabilitiesPostemployment Liabilities

Medical bills for retired employeesMedical bills for retired employees

Reported as liability on balance sheetReported as liability on balance sheet

Deferred Income TaxesDeferred Income Taxes

Financial Statement Income DOES Financial Statement Income DOES NOT NECESSARILY EQUAL Taxable NOT NECESSARILY EQUAL Taxable Income!!!Income!!!

Taxes paid are based on TAXABLE Taxes paid are based on TAXABLE income as defined by the IRS; tax income as defined by the IRS; tax expense reported on income statement expense reported on income statement is based on FINANCIAL statement is based on FINANCIAL statement incomeincome

Deferred Income Taxes (cont.)Deferred Income Taxes (cont.)

Deferred Income Taxes result from Deferred Income Taxes result from TIMING (temporary) differences in taxable TIMING (temporary) differences in taxable and financial statement incomeand financial statement income

Examples are many:Examples are many:– depreciation (major difference for many)depreciation (major difference for many)– pension expensepension expense– installment sale accountinginstallment sale accounting– othersothers

More on Deferred TaxesMore on Deferred Taxes

Classification may be current or long-term Classification may be current or long-term depending on the asset or liability depending on the asset or liability underlying the temporary differenceunderlying the temporary difference

Most are found in the long-term liability Most are found in the long-term liability sectionsection

Other Long-Term DebtOther Long-Term Debt

Once again, a “catch-all” category for long Once again, a “catch-all” category for long term obligations not reported elsewhereterm obligations not reported elsewhere

Keeping debt off the books Keeping debt off the books – EnronEnron

----------------------------------------------------

NOW, WHAT ABOUT OWNER NOW, WHAT ABOUT OWNER CLAIMS???CLAIMS???

Stockholders’ EquityStockholders’ Equity

Represent claims to assets by OWNERS, Represent claims to assets by OWNERS, i.e. stockholdersi.e. stockholders

Is often referred to as a RESIDUAL; this Is often referred to as a RESIDUAL; this flows from a restatement of the basic flows from a restatement of the basic equation:equation:

ASSETS - LIABILITIES = EQUITIESASSETS - LIABILITIES = EQUITIES

More on Stockholders’ EquityMore on Stockholders’ Equity

Usually consists of STOCK ACCOUNTS Usually consists of STOCK ACCOUNTS AND ADDITIONAL PAID-IN CAPITAL and AND ADDITIONAL PAID-IN CAPITAL and RETAINED EARNINGS -- may have other RETAINED EARNINGS -- may have other equity accountsequity accounts

Additional paid-in capital is the difference Additional paid-in capital is the difference between par value and what was received between par value and what was received for the stockfor the stock

StockStock

Par, no par and stated valuePar, no par and stated value

Market, book, liquidation, redemption Market, book, liquidation, redemption valuevalue

Authorized, issued, outstandingAuthorized, issued, outstanding

Common vs. preferredCommon vs. preferred

Cumulative vs. non-cumulativeCumulative vs. non-cumulative

Convertible vs. non-convertibleConvertible vs. non-convertible

CallableCallable

Stock vs. BondStock vs. Bond

Bond is debt, stock is ownershipBond is debt, stock is ownership

Bonds mature, stock doesn’tBonds mature, stock doesn’t

Most bonds require periodic interest Most bonds require periodic interest payments. Dividends payable only when payments. Dividends payable only when declareddeclared

Bond interest deductible for both book and Bond interest deductible for both book and tax, dividends are not.tax, dividends are not.

Retained EarningsRetained Earnings

In simplest terms, represents the In simplest terms, represents the cumulative undistributed earnings of the cumulative undistributed earnings of the business since its inceptionbusiness since its inception

Represent funds the company has chosen Represent funds the company has chosen to “retain” and reinvest in the businessto “retain” and reinvest in the business

RETAINED EARNINGS DOES NOT RETAINED EARNINGS DOES NOT REPRESENT A PILE OF CASH!!!!!!!REPRESENT A PILE OF CASH!!!!!!!

““Other” Equity Accounts?Other” Equity Accounts?

Can include such things as unrealized Can include such things as unrealized holding gains/losses on investments, holding gains/losses on investments, treasury stock, foreign currency translation treasury stock, foreign currency translation effectseffects

So, What Have We Learned?So, What Have We Learned?

Balance Sheet is a “snapshot”Balance Sheet is a “snapshot”

Assets = Liabilities & EquitiesAssets = Liabilities & Equities

Can “walk” through a balance sheet and Can “walk” through a balance sheet and (a) understand what the account titles (a) understand what the account titles mean and (b) have at least the beginnings mean and (b) have at least the beginnings of an understanding of where some of the of an understanding of where some of the numbers come fromnumbers come from

Caution FlagsCaution Flags

Reductions in the allowance for doubtful accounts when Reductions in the allowance for doubtful accounts when accounts receivable are increasingaccounts receivable are increasingSales and receivables growing at substantially different Sales and receivables growing at substantially different rates or moving in opposite directionsrates or moving in opposite directionsSales and inventories growing at substantially different Sales and inventories growing at substantially different rates or moving in opposite directions.rates or moving in opposite directions.Categories of inventories moving in opposite directionsCategories of inventories moving in opposite directionsExcessive use of “other” for material, unexplained itemsExcessive use of “other” for material, unexplained itemsWrite-down in value of goodwillWrite-down in value of goodwillBorrowings growing faster than assets being financed; Borrowings growing faster than assets being financed; debt rising when assets are decreasingdebt rising when assets are decreasing

Caution Flags cont’dCaution Flags cont’d

Financial statement notes obscure rather than Financial statement notes obscure rather than enlightenenlightenChanges in and additions to financial statement Changes in and additions to financial statement notes require PhD in accounting and notes require PhD in accounting and measurement by yardstick rather than rulermeasurement by yardstick rather than rulerSubstantial amount of income from Substantial amount of income from unpredictable and possibly unsustainable unpredictable and possibly unsustainable sources, such as pension planssources, such as pension plansExtensive use of stock options for employee Extensive use of stock options for employee compensationcompensation

So What’s Next?So What’s Next?

Everything you want or need to know cannot Everything you want or need to know cannot be found on the balance sheetbe found on the balance sheet

Next we will look at the income statement Next we will look at the income statement and try to understand what it’s trying to tell and try to understand what it’s trying to tell usus

Also, we need to become aware there are Also, we need to become aware there are many important relationships between many important relationships between income statement and balance sheet income statement and balance sheet items……..items……..

Valedico! Valedico!

Powerpoint

Economy & Finance

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