The Balance The Balance Sheet and Sheet and

Notes to the Notes to the Financial Financial

StatementsStatements

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Describe the specific elements of the balance sheet (assets, liabilities, and owners’ equity) and prepare a balance sheet with assets and liabilities properly classified into current and noncurrent categories.

Identify the different formats used to present balance sheet data.

Learning Objectives

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Learning Objectives

Analyze a company’s performance and financial position through the computation of financial ratios.

Recognize the importance of the notes to the financial statements, and outline the types of disclosures made in the notes.

Understand the major limitations of the balance sheet.

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Usefulness of the Balance Sheet

• Reports the resources (assets), obligations (liabilities), and residual ownership claims (equity) of a company.

• Facilitates analysis of the company’s ability to:– meet short-term obligations (liquidity).– pay all debts as due (solvency).

• Provides information about the company’s financial flexibility.

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Elements of the Balance Sheet

Assets

Probable future Probable future economic benefit economic benefit

obtained or obtained or controlled by a controlled by a

particular entity as particular entity as a result of past a result of past transactions or transactions or

eventsevents

The inclusion of “probable”

acknowledges that accounting is not an exact

science.

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Elements of the Balance Sheet

The primary purpose of the

balance sheet is to help forecast

the future.

Assets

Probable future Probable future economic benefit economic benefit

obtained or obtained or controlled by a controlled by a

particular entity as particular entity as a result of past a result of past transactions or transactions or

eventsevents

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Elements of the Balance Sheet

Typical assets found on a balance sheet are cash,

supplies, accounts receivable, land, buildings,

and equipment.

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Elements of the Balance Sheet

Liability

Probable future sacrifice Probable future sacrifice of economical benefit of economical benefit arising from a present arising from a present

obligation of a particular obligation of a particular entity to transfer assets or entity to transfer assets or provide services to other provide services to other entities in the future as a entities in the future as a result of past transactions result of past transactions

or events.or events.

“Obligation” includes legal, moral, social, and implied

commitments.

Liability

Probable future sacrifice Probable future sacrifice of economical benefit of economical benefit arising from a present arising from a present

obligationobligation of a particular of a particular entity to transfer assets or entity to transfer assets or provide services to other provide services to other entities in the future as a entities in the future as a result of past transactions result of past transactions

or events.or events.

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Elements of the Balance Sheet

Liability

Probable future sacrifice Probable future sacrifice of economical benefit of economical benefit arising from a present arising from a present

obligation of a particular obligation of a particular entity to transfer assets or entity to transfer assets or provide servicesprovide services to other to other entities in the future as a entities in the future as a result of past transactions result of past transactions

or events.or events.

An obligation to provide services

is a liability.

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Typical liabilities include accounts

payable, notes payable, and advances from

customers.

Elements of the Balance Sheet

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Elements of the Balance Sheet

Equity

Residual interest in the assets of an entity that remains after deducting its liabilities.

Capital StockCapital StockRetained EarningsRetained Earnings

Paid-in Capital in Excess of ParPaid-in Capital in Excess of Par

12How to Classify Items on the Balance Sheet

Current (one year or less)

Noncurrent (more than 1 year)

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Current Assets

Cash and resources expected to be converted to cash during the entity’s normal operating cycle or one year, whichever is longer, are current assets.

• Cash• Accounts and notes receivable• Inventories• Prepaid items

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Operating Cycle

Receivables

Cash

Inventories

PurchasesCollections

Sales

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Noncurrent Assets

• Investments • Property,

plant, and equipment

• Deferred income taxes

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Property, Plant, and Equipment

Property, plant, and equipment are properties of a tangible and

relatively permanent nature that are used in the normal business

operations.

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Intangible Assets

Intangible assets are long-term rights and

privileges of a nonphysical nature acquired for use in

business operations.

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Current Liabilities

Current liabilities are obligations expected to be paid within one year or the normal operating cycle.

• Accounts and notes payable• Accrued expenses• Current portion of long-term

obligations• Unearned revenues

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Current Liabilities

If the terms of the agreement for a callable

obligation is due on demand or will become due on demand within

one year from the balance sheet date, the obligation should be classified as current.

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Noncurrent Liabilities

The current liability classification generally does not include the following items: Debts to be liquidated from a noncurrent

sinking fund.

Short-term obligations to be refinanced.

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Noncurrent Liabilities

• Long-term debt• Long-term lease

obligations• Deferred income

tax liability• Pension

obligations

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Noncurrent Liabilities

Long-term debt is reported at its discounted

present value.

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Contingent Liabilities

Past activities or circumstances may give rise to possible

future liabilities. Potential obligations that do not exist on the balance sheet date are known as

contingent liabilities.

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Contingent Liabilities

An estimated liability is a definite liability, so it is

not a contingent liability.

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Owners’ Equity

Contributed Capital: Capital stock Additional paid-in capital

Capital stock usually is the number of shares

issued multiplied by the par or stated value.

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Owners’ Equity

Contributed Capital: Capital stock Additional paid-in capital

The two types of capital stock are preferred and

common.

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Owners’ Equity

Contributed Capital: Capital stock Additional paid-in capital

Additional paid-in capital is the excess

invested above par or stated value of the

capital stock.

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Owners’ Equity

Retained earnings is the amount of undistributed earnings of past periods.

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Evaluating Liquidity

Current Ratio: current assets divided by current liabilities.

Quick Ratio: quick assets divided by current liabilities (Acid-Test Ratio).

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Liquidity Ratios Example

Cash $ 30Net Accounts Receivable 70Inventory 100Current Assets $200Current Liabilities $100

Current AssetsCurrent Assets

Current LiabilitiesCurrent Liabilities$200$200

$100$100= 2:1

Current RatioCurrent Ratio

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Liquidity Ratios Example

Quick AssetsQuick Assets

Current LiabilitiesCurrent Liabilities

$100$100

$100$100= 1:1

Cash $ 30Net Accounts Receivable 70Inventory 100Current Assets $200Current Liabilities $100

Cash $ 30Net Accounts Receivable 70Inventory 100Current Assets $200Current Liabilities $100

Quick RatioQuick Ratio

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Current Ratio

McDonald’s 0.5

Microsoft 2.8

Disney 1.2

Coca-Cola 0.7

Yahoo! 5.8

Coke

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Overall Leverage

Debt Ratio: total liabilities divided by total assets.Total Assets $400Total Liabilities 300

Total LiabilitiesTotal Liabilities

Total AssetsTotal Assets

$300$300

$400$400= 75%

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Debt Ratio

McDonald’s 52.2%

Microsoft 25.6%

Disney 53.1%

Coca-Cola 56.1%

Yahoo! 13.8%

Coke

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Asset Mix

The proportion of total assets in each asset category.Property, Plant, and Equipment $ 50Total Assets 400

Asset GroupAsset Group

Total AssetsTotal Assets

$50$50

$400$400= 12.5%

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Efficiency

“Asset Turnover” is a financial ratio measuring how efficiently a company uses its assets to generate sales. Sales $200Total Assets 400

SalesSales

Total AssetsTotal Assets$200$200

$400$400= 0.50

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Asset Turnover

McDonald’s 0.63

Microsoft 0.65

Disney 0.56

Coca-Cola 0.98

Yahoo! 0.33

Coke

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Overall Profitability

Two ratios that measure overall profitability are “Return on Assets” and “Return on Equity.”Net Income $ 40Total Assets 400Stockholders’ Equity 160

Net IncomeNet Income

Total AssetsTotal Assets

$40$40

$400$400= 10.0%

Return on AssetsReturn on Assets

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Return on Assets

McDonald’s 7.8%

Microsoft 20.2%

Disney 4.5%

Coca-Cola 18.5%

Yahoo! 4.1%

Coke

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Overall Profitability

Two ratios that measure overall profitability are “Return on Assets” and “Return on Equity.”Net Income $ 40Total Assets 400Stockholders’ Equity 160

Net IncomeNet Income

Stockholders’ EquityStockholders’ Equity

$40$40

$160$160= 0.25%

Return on EquityReturn on Equity

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Return on Equity

McDonald’s 16.4%

Microsoft 27.0%

Disney 9.5%

Coca-Cola 42.0%

Yahoo! 4.8%

Coke

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Notes to Financial Statements

• Summary of significant accounting policies.

• Additional information to support summary totals.

• Information about items not included in financial statements.

• Supplementary information required by the FASB or the SEC to fulfill the full-disclosure principle.

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Subsequent Events

Financial StatementPeriod

SubsequentPeriod

Balance Sheet Date

Date Statements Issued

Events in this periodmay affect the reporting

of amounts in thesubsequent periods

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•Types of Events•Those that materially affect one or more financial statements.•Those that create a need for a footnote.

Subsequent Events

Balance Sheet Date

Date Statements Issued

Financial StatementPeriod

SubsequentPeriod

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Limitations of the Balance Sheet

Does not disclose actual value of the entity.

Does not disclose effects of inflation. Classifications are not uniform among

companies. Does not disclose all assets and liabilities.

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The End