Lecture Notes for Chapter 5

The Balance Sheet and the Statement of Cash Flows

I. Usefulness of the Balance Sheet

A. The balance sheet provides information about the nature and amounts of investments in enterprise resources, obligations to creditors, and owners' equity.

B. The balance sheet provides a basis for

1. Computing rates of return

2. Evaluating the capital structure of the enterprise; think in terms of debt to equity ratio and A = L + OE.

3. and assessing the liquidity, solvency and financial flexibility of the enterprise; .

C. Liquidity describes "the amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid." Creditors are concerned with a firm's liquidity.

D. Solvency is the ability to pay one’s debts.


E. Financial flexibility is "the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities."

II. Limitations of the Balance Sheet

A. The balance sheet does not reflect current values for assets. The balance sheet often uses historical cost as the basis to value assets.

B. Some accountants believe that the balance sheet would be more relevant to decision makers if it valued assets at current values. However, there is no consensus as to what is meant by current value.

1. Some believe that historical cost should be adjusted for inflation. This is called the constant dollars approach, and would adjust for the fact that the monetary unit is not stable over time.

2. Others believe that historical cost should be replaced by current cost. Current cost is what the firm would have to pay for the same asset today.

3. Others argue for net realizable value. This is what we could expect to sell the asset for in the normal course of business.

4. Still others argue that the asset should be valued at the present value of its expected future cash flows. This is the present value concept.

5. The argument could be made that any one of these methods would be more relevant than historical cost accounting, and from time to time GAAP will require us to deviate from historical cost and use one of these other methods.

6. The greatest shortcomings of these alternative valuation methods are in the areas of

a. Reliability

b. and Cost/Benefit


7. Most recently, when one speaks of an alternative to historical cost, one refers to “Fair Value” measures. These have a hierarchy.

            a. Level 1- refers to use of market prices of the asset being valued.

                        b. Level 2- refers to use of market prices of assets “similar” to the one being valusd.

c. Level 3- refers does not refer to market prices, but rather to prices derived from an economic mode. Present value models are often used for this purpose.

C. Returning to limitations of the B.S., judgments and estimates must be used in interpreting the balance sheet. For example, in the areas of

1. The collectability of receivables,

2. The salability of inventory,

3. and the useful life of long term assets,

4. judgment is required.

D. Please note that the balance sheet omits many items that are of financial value to the business

1. A well trained work force is a valuable resource to the firm, but it will not appear on the balance sheet as an asset.

2. The business may have cultivated a loyal clientele, but this fact does not show up on the balance sheet.

3. The firm may have conducted important research and development activities in the past, but these costs do not show up as assets on the balance sheet.

III. Classification in the Balance Sheet

A. We know that the elements of the balance sheet are

1. Assets

2. Liabilities

3. and owners' equity

B. Balance Sheet accounts are classified so that similar items are grouped together to arrive at significant subtotals.

C. The balance sheet sub-classifications appear in the beige box in the center of page 180.

D. Used more narrowly, the term classified means that the balance sheet makes a distinction between current and non-current items.

IV. Current Assets

A. Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in one operating cycle, whichever is longer.

B. Current assets are presented in the balance sheet in the order of liquidity.

C. Current assets include the following:

1. Cash, the most liquid asset is presented at its stated value.

2. Short-term investments are valued at fair value.

3. Accounts receivable are valued at NRV.

4. Inventories are valued at cost or the LCM.

5. and prepaid items are valued at cost.

V. Cash

A. Any restrictions on the general availability of cash or any commitments on its probable disposition must be disclosed.

B. If cash is restricted for purposes other than current obligations, it is excluded from current assets.

VI. Short term investments

A. Investments in debt and equity securities are grouped into three separate portfolios for valuation and reporting purposes:

1. Held to maturity

a. This is the classification used for debt securities which the firm has the positive intent and ability to hold to maturity,

b. Any debt security which the firm intends to hold for an indefinite period of time is not to be classified as a held to maturity security.

c. Held to maturity securities are carried at amortized cost, not at fair value.

2. Trading

a. This is the classification used for debt and equity securities bought and held primarily for sale in the near future,

b. Trading securities are carried at fair value.

3. Available for sale

a. This is the classification used for debt and equity securities not classified as held to maturity or trading.

b. Available for sale securities are to be reported at fair value.

B. All of these rules are summarized for you in the box on page 859.

VII. Receivables

A. are valued at net realizable value.

B. We must disclose

1. anticipated loss due to uncollectibles

2. The amount and nature of any non-trade receivables

3. and any amounts pledged or discounted.

4. An example is given on page 183.

VIII. Inventories

A. We must disclose

1. The cost flow assumption used to value the inventories



c. Average

d. or specific identification

2. We must also disclose the state of completion of the inventory

a. RM

b. WIP

c. FG

IX. Prepaid Expenses are the last item included in the current asset section. Prepaid expenses are reported at unexpired or unconsumed cost.

X. Long Term Investments

A. These are assets held by the firm for more than one year, which are not currently being used in the operations of the firm.

B. Your author lists four types on pages 184 and 185.

1. Securities which management intends to hold long term.

2. Tangible assets not used in operations, but rather, held for speculative purposes.

3. Investments set aside in special funds.

4. and investments in subsidiaries.

C. This section of the balance sheet is illustrated on page 185.

XI.PP&E and Intangible Assets

A.PP&E used to be called fixed assets.

B.PP&E consists of

1. Long lived assets,

2. Tangible in nature,

3. which are used in operations.

C. With the exception of Land, the cost of these assets is depreciated over time or with use.

D. The PP&E section of a B.S. is illustrated at the top of page 185.

E. Intangible assets are

1. Are not financial instruments and

2. Lack physical substance.

3. Examples include

a. patents

b. copyrights

c. and goodwill.

6. The intangible section of a B.S. is shown on page 186.

XII. Other Assets

A. This section should be used as little as possible. It should be restricted to unusual items sufficiently different from assets included in specific categories.

B. Examples would include items such as long term pre-paid expenses.

XIII. Current Liabilities include

A. Payables expected to be liquidated through the use of current assets or the creation of other current liabilities

B. Collections received in advance

C. and other liabilities whose liquidation will take place during one year or one operating cycle whichever is longer. Note that this includes the currently maturing portion of long term debt.

D. The current liability section of the Balance Sheet is illustrated on page 187.

E. One measure of liquidity is working capital. Working capital is defined as current assets minus current liabilities. This figure does not appear on the balance sheet but is calculated by financial analysts.

XIV. Long term liabilities

A. This section includes all obligations not expected to be liquidated within one year or one operating cycle whichever is longer.

B. Examples include

1. B/P, along with separate presentation of any discount or premium,

2. Long term N/P,

3. credits to the deferred income tax account,

4. lease obligations,

5. and pension obligations.

C. The notes to the statement should disclose

1. the maturity dates of the L.T. debt,

2. the rates of interest,

3. the nature of the obligation,

4. and security pledged, if any.

XV. Owners' Equity

A. The stockholders' equity section is on page 189.

B. Capital stock disclosure requirements include

1. the number of shares authorized,

2. the number of shares issued,

3. the number of shares outstanding,

4. and the par value amounts.

XVI. Form

A. The account form presents the assets on the left side and the liabilities and owners' equities on the right side.

B. The report form presents the assets on the top, and the liabilities and the owners' equity on the bottom.

XVII. Additional Information Reported

A. Four types of supplemental balance sheet information are commonly presented

1. contingencies,

2. valuations and accounting policies,

3. contractual situations,

4. and Fair Values

B. Contingencies are material events that have an uncertain outcome.

1. Gain contingencies are not recorded in the accounting system . This treatment is justified by the constraint of conservatism. If the probability is high that the gain contingency will become a reality, it may be disclosed in the notes.

2. Loss contingencies are handled differently based on the probability that the contingency will become a reality. See pg. 652.

a. There are three gradations of probability according to SFAS No. 5

(1) Probable

(2) Reasonably possible

(3) and remote

b. If the loss is probable, and if the amount of the loss can be reasonably estimated, then you should debit a loss account and credit a liability account.

c. If the loss is at least reasonably possible, you should footnote disclose

(1) the nature of the contingency

(2) and an estimate of the amount involved, if one can be made.

d. If the probability of loss is remote, you need not do anything.

XVIII. Valuations and accounting policies: APB Opinion No. 22 requires disclosure of all significant accounting principles and methods that involve selection from among alternatives or those that are peculiar to a given industry. See page 222.

XIX. Contracts and Negotiations of significance should be disclosed in the notes of the statements.

XX. Techniques of Disclosure

A. Parenthetical Explanations are explanations in parenthesis (see pg. 194)

B. Notes are used to provide additional explanations or descriptions which cannot be shown conveniently as parenthetical explanations. (see pg. 195)

C. Cross reference and contra items

1. A direct relationship between an asset and a liability is "cross referenced" on the balance sheet. See the middle of page 196.

2. Contra accounts are used to reduce the book value of a balance sheet item. Accumulated depreciation is an example.

3. Adjunct accounts are used to increase the magnitude of a balance sheet item. Premium on bonds payable is an example.

D. Supporting schedules are a means of presenting more detailed information about certain assets or liabilities than could be easily provided on the balance sheet.

XXII. Terminology

A. In the past the term Reserve has been used by many different people to mean many different things, such as:

1. A contra asset account (allowance for bad debts)

2. or a liability for a contingency (estimated warrantee liability)

3. or appropriated retained earnings

B. As a result the term has lost all meaning

1. The author recommends you only use the term to mean appropriated retained earnings.

2. I recommend that you never use the term at all.

C. Another confusing word is surplus. The term is frequently used to mean additional paid in capital in excess of par value. I recommend you never use the word surplus, but use APIC instead.

XXIII. The Statement of Cash Flows

A. One of the three basic objectives of financial reporting is to "assess the amounts, timing, and uncertainly of cash flows." This is accomplished with the cash flow statement.

B. The primary purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period.

C. The statement reports

1. The cash effects of an enterprise's operations during the period

2. The firm’s investing transactions

3. The firm's financing transactions

4. and the net increase or decrease in cash during the period.

D .Another way of saying this is that the statement reports

1. the sources

2. and uses of cash as well as

3. the net increase

4. or decrease in cash.

E. This information is very relevant to present and potential creditors and investors.

F. Content and format of the statement of cash flows

1. Cash receipts and cash payments are classified into one of three different sections

a. operating activities

b. investing activities

c. and financing activities

2. Operating activities involve the cash effect of those transactions which enter into the determination of net income.

3. Investing activities involve the cash effect of transactions related to the making and collecting of loans, acquiring and disposing of investments, and acquiring and disposing of property plant and equipment.

4. Financing activities involve the cash effect of transactions related to long term liabilities and owners' equity.

G. Preparation of the Statement of Cash Flows

1. This topic is covered in detail in Chapter 24. In chapter 5 we will only cover the basics

2. Look at the comprehensive example presented at the bottom of page 195.

a. Our first concern is cash provided by operations. We will calculate this figure by converting accrual based net income to cash based cash inflows from operations. This is done by undoing the accruals and deferrals, and by adding back in any non-cash expenses such as depreciation, amortization, or deferred taxes.

b. Next we will calculate cash from investing activities.

c. And finally cash from financing activities.


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