Chapter 5: Balance Sheet Chapter 5: Balance Sheet and Statement of Cash and Statement of Cash

Flows SystemsFlows Systems

Part 1: The Balance SheetPart 1: The Balance Sheet

Provides information for evaluating:

Capital structureRates of return

Balance Sheet: UsefulnessBalance Sheet: Usefulness

Provides information for evaluating:Analyzing an enterprise’s:

LiquidityTime to elapse until converted to cash/liability

has to be paidSolvency

Ability to pay debts when dueFinancial flexibility

Ability to alter amounts & timing of cash flows to respond to unexpected situations

Affected by liquidity & solvency

Balance Sheet: UsefulnessBalance Sheet: Usefulness

• Most assets & liabilities stated at historical cost

• Judgments & estimates used• Does not report items that can not

be objectively determined• Does not report information

regarding off-balance sheet financing– FIN 45 & FIN 46

Balance Sheet: LimitationsBalance Sheet: Limitations

Guidelines for reporting assets & liabilities separately:

• Type/expected function in central operations– Inventories vs. PP&E

• Implications for financial flexibility– Assets used in operations vs. invested

• Liquidity characteristics– Cash vs. inventories vs. AR

Balance Sheet: Balance Sheet: ClassificationClassification

• Current Assets• Long-term

investments• Property, plant,

& equipment• Intangible

assets• Other assets

• Current liabilities• Long-term debt• Owners’ equity

– Capital stock– Additional paid-in

capital– Retained earnings

Assets Liabilities and Equity

Balance Sheet: Balance Sheet: ClassificationClassification

• Expected to be consumed, sold, or converted into cash:– Either in one year or in operating cycle,

whichever is longer

• Presented in order of liquidity– Illustration 5-9 page 177

• Valuation principles– Certain short-term investments = fair

value• Trading, available-for-sale, held-to-maturity

– Accounts receivable = net realizable value

Current AssetsCurrent Assets

• Don’t meet definition for current– LT investments

• Illustration page 178

– PP&E• Illustration page 178

– Intangibles• Illustration page 179

– Other assets• Vary widely in practice

Non Current AssetsNon Current Assets

Long-term investments may be:• Securities

– Bonds, stocks• Fixed assets

– Land not used in operations, held for investment

• Amounts set aside in special funds– Sinking fund

• Unconsolidated subsidiaries or affiliated companies

Long-Term InvestmentsLong-Term Investments

• Current liabilities are liquidated:– Either through the use of current assets, or– By creation of other current liabilities– Exception = refinanced/retired from LT assets

• Examples– Payables resulting from acquisitions of goods &

services– Collections received in advance of services– Other liabilities which will be paid in the short

term

• Illustration 5-13 page 180

Current LiabilitiesCurrent Liabilities

• Long-term obligations are those not expected to be paid within the operating cycle

• Examples – Obligations arising from specific

financing situations (issuance of bonds)– Obligations arising from ordinary

business operations (pension obligations)

– Obligations that are contingent (product warranties)

• Illustration 5-14page 181

Long-Term LiabilitiesLong-Term Liabilities

• Capital stock• Additional paid-in-capital• Retained earnings• Partnership/sole proprietors

– Capital (permanent) drawing (temporary) separate

• Illustration 5-15 page 182

Owners’ EquityOwners’ Equity

• Account form– Assets on left side– Liabilities & SE on right side

• Report form– Pancake – Illustration 5-16 page 183

Balance Sheet FormatBalance Sheet Format

• Supplemental information – Not presented elsewhere– Qualifies items in the balance sheet– Examples

• Accounting policies (FN 1 or 2)• Contractual situations• Covenant restrictions• Fair values

– Illustration page 187• Material events having an uncertain

outcome– Illustration page 185

Balance Sheet: Additional Balance Sheet: Additional Information ReportedInformation Reported

• Parenthetical explanations• Notes

– Illustrations page 188

• Cross references and contra/adjunct items– Illustrations page 189

• Supporting schedules– Illustration page 189

Balance Sheet: Techniques Balance Sheet: Techniques of Disclosureof Disclosure

Part 2: The Statement of Part 2: The Statement of Cash FlowsCash Flows

• Provides information about:– Cash receipts (cash inflows)– Uses of cash (cash outflows) – During a period of time

• Helps users evaluate– Liquidity

• Nearness of cash

– Solvency• Ability to pay debts

– Financial flexibility • Ability to respond & adapt to changes

The Cash Flow StatementThe Cash Flow Statement

• Information comes from– Comparative BS– Current IS– Selected transaction data

• Inflows and outflows are reported for:– Operating– Investing – Financing activities

The Cash Flow StatementThe Cash Flow Statement

•Steps– Determine cash provided/used by

operations– Determine cash provided/used by

• Investing•Financing

– Determine change in cash for period

– Reconcile change in cash• Illustrations page 194 & 195

The Cash Flow StatementThe Cash Flow Statement

Cash Inflows and OutflowsCash Inflows and Outflows

• There are two methods of preparing:– Indirect method

• Most common in practice• Derives cash flows from accrual

based statements• Illustration page 194

– Direct method• Derives cash flows directly for each

source or use of cash

Preparing a Statement of Preparing a Statement of Cash FlowsCash Flows

Accrual Based Statements Cash Flow Statement

Income Statementitems & Changes inCurrent Assets andCurrent Liabilities

Operating activities:Adjust net income for accrualsand non-cash charges to get cash flows

Balance Sheet: Changes inNon-Current Assets

Investing activities:Inflows from sale of assets and Outflows from purchases of assets

Balance Sheet: Changes inNon-Current Liabilities

andEquity

Financing activities:Inflows and outflowsfrom loan and equitytransactions

The Statement of Cash The Statement of Cash Flows: Indirect MethodFlows: Indirect Method

Ratio analysis expresses the relationship between selected financial data.

These relationships can be expressed as:

• Percentages • Rates• Proportions

Ratio AnalysisRatio Analysis

25Intermediate Accounting, 10th Edition, Ch. 5 (Kieso et al.)

04/10/23Coverage ratiosSome protection forLT creditors &investors

Debt to total assetsTimes interest earned

Type What is measured Examples

Liquidity ratiosShort-term ability to pay maturing obligations

Current ratioQuick assets ratio

Profitability ratios

Degree of success orfailure for a given period

Return on assetsEarnings per share

Activity ratios Effectiveness in using assets employed

Receivables turnoverInventory turnover

Types of RatiosTypes of Ratios

• Liquidity ratio (high)– Current assets / current liabilities

• Current cash debt coverage ratio (high)– Ability to pay CL in given year from operations

• Net cash operating activities / average current liabilities

• Cash debt coverage ratio (high)– Ability to pay liabilities from net cash from

operations w/o liquidating assets• Net cash operating activities / average total liabilities

Ratio AnalysisRatio Analysis

• Free cash flow– Measures financial flexibility

• Discretionary cash flow available for – Additional investments– Debt retirement– Purchase treasury stock

– FormulaNet cash from operating activitiesLess

Capital outlayDividends

– Illustration page 198

Cash Flow AnalysisCash Flow Analysis

Class exercisesE5-3 E5-4 E5-6E5-8 E5-9 E5-13E5-14

Balance Sheet & Balance Sheet & Statement of Cash FlowsStatement of Cash Flows