ACCT550 Ch 5 Summary for Students

8/10/2019 ACCT550 Ch 5 Summary for Students

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CHAPTER 5

Balance Sheet and Statement of Cash Flows

LEARNING OBJECTIVES

1. Explain the uses and limitations of a balance sheet.2. Identify the major classifications of the balance sheet.

3. Prepare a classified balance sheet using the report and account formats.

4. Indicate the purpose of the statement of cash flows.

5. Identify the content of the statement of cash flows.

6. Prepare a basic statement of cash flows.

7. Understand the usefulness of the statement of cash flows.

8. Determine which balance sheet information requires supplemental disclosure.

9. Describe the major disclosure techniques for the balance sheet.

*10. Identify the major types of financial ratios and what they measure.*11. Compare the accounting procedures related to the balance sheet under GAAP a

IFRS.

Copyright 2013 John Wiley & Sons, Inc. Ki eso, Intermediate Accounting,15e Instructors Manual ( For Instructor Use Only)


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CHAPTER REVIEW

*Note: Al l asterisked (*) items relate to material contained in the Appendix to the chapter.

1. Chapter 5 presents a detailed discussion of the concepts and techniques that underlie thepreparation and analysis of the balance sheet. Along with the mechanics of preparation,acceptable disclosure requirements are examined and illustrated. A brief introduction tothe statement of cash flows is also presented. This explanation serves as a foundation for

the more comprehensive discussion of this subject presented in Chapter 23. At the end ofChapter 5, a multi-page illustration of the financial statements and accompanying notesof a corporation are presented. This illustration may be referred to throughout the study ofintermediate accounting as it includes information relevant to many of the topics discussedin subsequent chapters.

Usefulness of the Balance Sheet

2. (L.O. 1) For many years financial statement users generally considered the incomestatement to be superior to the balance sheet as a basis for judging the economic well-being of an enterprise. However, the balance sheet can be a very useful financial statement.

If a balance sheet is examined carefully, users can gain a considerable amount of informationused to assess liquidity, solvency and financial flexibility.Liquidity is generally relatedto the amount of time that is expected to elapse until an asset is realized or otherwiseconverted into cash or until a liability has to be paid. Solvency refers to the ability of anenterprise to pay its debts as they mature. Financial flexibility is the ability of an enterpriseto take effective action to alter the amounts and timing of cash flow so that it can respondto unexpected needs and opportunities.

Limitations of the Balance Sheet

3. Criticism of the balance sheet has revolved around the limitations of the informationpresented therein. These limitations include:

(a) Failure to reflect current value information.(b) The extensive use of judgment and estimates.(c) Failure to include items of financial value that cannot be recorded objectively.

4. The problem with current value information concerns the reliability of such information.The estimation process involved in developing current-value type information causesa concern about the objectivity of the resulting financial information. The use of estimatesis extensive in the development of balance sheet data. These estimates are required bygenerally accepted accounting principles, but reflect a limitation of the balance sheet. Thelimitation concerns the fact that the estimates are only as good as the understanding andobjectivity of the person(s) making the estimates. The final limitation of the balance sheetconcerns the fact that some significant assets of the entity are not recorded. Items suchas human resources (employee workforce), managerial skills, customer base, and reputationare not recorded because such assets are difficult to quantify.

5-2 Copyright 2013 John Wiley & Sons, Inc. Ki eso, Intermediate Accounting,15/e Instructors Manual ( For Instructor Use Only)


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Classification in the Balance Sheet

5. (S.O. 2) The major classifications used in the balance sheet are assets, liabilities,equity.

To provide the financial statement reader with additional information, these mclassifications are divided into several subclassifications. Assets are further classifiedcurrent or noncurrent, with the noncurrent divided among long-term investme

property, plant, and equipment; intangible assets; and other assets. Liabilities are classas currentor noncurrent. Owners equity includes capital stock, additional paid-in capand retained earnings.

Assets.

Probable future economic benefits obtained or controlled by a particuentity as a result of past transactions or events.

Liabilities.Probable future sacrifices of economic benefits arising from presobligations of a particular entity to transfer assets or provide services to other entitiethe future as a result of past transactions or events.

Equity.

Residual interest in the assets of an entity that remains after deductingliabilities. In a business enterprise, the equity is the ownership interest.

Current Assets

6. Current assets are cash and other assets a company expects to convert into cash, sor consume either in one year or in the operating cycle, whichever is longer. Currassets are presented in the balance sheet in the order of their liquidity and normally inclcash and cash equivalents, short-term investments, receivables, inventories, and prepexpenses.There are some exceptions to a literal interpretation of the current adefinition. These exceptions involve prepaid expenses, investments in common stock,

the subsequent years depreciation of fixed assets. These exceptions are recognized inaccounting process and are understood by most financial statement users.

Reporting Current Assets

7. Any restrictions on the general availability of cashor any commitments on its probadisposition must be disclosed. Short-term investments are usually categorized as hto-maturity, trading, or available-for-sale. Any anticipated loss due to uncollectibles, amount and nature of any nontrade receivables, and any receivables designatedcollateral should be clearly identified. For a proper presentation of inventories,the bof valuation (i.e., lower of cost or market) and the method of pricing (FIFO or LIFO) sho

be disclosed. A company includes prepaid expensesin current assets if it will recebenefits within one year or the operating cycle, whichever is longer.



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Long-Term Investments

8. Items classified as long-term investments in the assets section of the balance sheetnormally are one of four types. These include:

a. Investments in securities, such as common stock, bonds, or long-term notes.

b. Investments in tangible fixed assets not currently used in operations.

c. Investments set aside in special funds (sinking, pension, plant expansion, etc.) andthe cash surrender value of life insurance.

d. Investments in nonconsolidated subsidiaries or affiliated companies.

Long-term investments are rather permanent in nature as they are not normally disposedof for a long period of time. They are shown in the balance sheet below current assets ina separate section called Investments.

Property, Plant and Equipment

9. Property, plant and equipmentare properties of a durable nature that are used in theregular operations of the enterprise. Examples include land, land improvements, buildings,machinery, furniture, tools, and wasting resources. With the exception of land, these assetsare either depreciable or depletable.

ntangible Assets

10. Intangible assets lack physical substance. However, their benefit lies in the rights theyconvey to the holder. Examples include patents, copyrights, franchises, goodwill, trademarks,trade names, and secret processes.

11. Limited-lifeintangible assets are amortized over their useful lives. Indefinite-life intan-gibles (such as goodwill) are not amortized but, instead, are assessed at least annuallyfor impairment.

Other Assets

12. Many companies include an Other Assets classification in the balance sheet afterIntangible Assets. This section includes a wide variety of items that do not appear to fallclearly into one of the other classifications. Some of the more common items included inthis section are: deferred charges, noncurrent receivables, prepaid pension costs,

deferred income taxes, and advances to subsidiaries.

Current Liabilities

13. Current liabilities are the obligations that are reasonably expected to be liquidated eitherthrough the use of current assets or the creation of other current liabilities. Items normallyshown in the current liabilities section of the balance sheet include notes and accountspayable, advances received from customers, current maturities of long-term debt, taxes



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payable, and accrued liabilities. Obligations due to be paid during the next year mayexcluded from the current liability section if the item is expected to be refinanced throlong-term debt or the item will be paid out of noncurrent assets.

14. Working capital is the excess of current assets over current liabilities. This concsometimes referred to as net working capital, represents the net amount of a comparelatively liquid resources.

Long-Term Liabilities

15. Long-term liabilities are obligations whose settlement dates extend beyond the noroperating cycle or one year, whichever is longer. Examples include bonds payable, nopayable, lease obligations, and pension obligations. Generally, the disclosure requments for long-term liabilities are quite substantial as a result of various covenants restrictions included for the protection of the lenders. Long-term liabilities that mature withe current operating cycle are classified as current liabilities if their liquidation requthe use of current assets. Long-term liabilities generally fall into one of the three followcategories:

a. Obligations arising from specific financing situations, such as the issuance of bonlong-term lease obligations, and long-term notes payable.

b. Obligations arising from the ordinary operations of the company such as pensobligations and deferred income tax liabilities.

c. Obligations that depend on the occurrence or non-occurrence of one or more fuevents to confirm the amount payable, or the date payable, such as product warranand other contingencies.

Owners Equity

16. The owners equity section of the balance sheet includes information related to capital stoadditional paid-in capital, and retained earnings. Preparation of the owners equity secshould be approached with caution because of the various restrictions imposed by stcorporation laws, liability agreements, and voluntary actions of the board of directors.

Balance Sheet Format

17. (L.O. 3) The account format of a classified balance sheet lists assets by sections onleft side and liabilities and stockholders equity by sections on the right side. The repformat lists liabilities and stockholders equity directly below assets on the same page.

Statement of Cash Flows

18. (L.O. 4) The primary purpose of a statement of cash flows is to provide relevinformation about the cash receipts and cash payments of an enterprise during a periThe statement of cash flows answers three questions:

a. Where did the cash come from during the period?



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b. What was the cash used for during the period?

c. What was the change in the cash balance during the period?

19. (L.O. 5) In accomplishing its purpose, the statement focuses attention on three differentactivities related to cash flows.

a. Operating activities involve the cash effects of transactions that enter into determinationof net income.

b. Investing activities include making and collecting loans and acquiring and disposingof debt and equity investments and property, plant, and equipment.

c. Financing activities involve liability and owners equity items and include (1) obtainingresources from owners and providing them with a return on their investment and(2) borrowing money from creditors and repaying the amounts borrowed.

The basic format of the statement of cash flows is shown below.

Statement of Cash Flows

Cash flows from operating activities................... $XXXCash flows from investing activities................... XXXCash flows from financing activities................... XXXNet increase (decrease) in cash......................... XXXCash at beginning of year.................................. XXXCash at end of year............................................ $XXX

20. The statement of cash flows value is that it helps users evaluate liquidity, solvency, andfinancial flexibility.

21. (L.O. 6) The information to prepare the statement of cash flows comes from three sources:(a) comparative balance sheets, (b) the current income statement, and (c) selectedtransaction data. Preparation of the statement of cash flows involves the following steps.

a. Determine the cash provided by operations.

b. Determine the cash provided by or used in investing and financing activities.

c. Determine the change (increase or decrease) in cash during the period.

d. Reconcile the change in cash with the beginning and the ending cash balances.

The information included in this chapter on the preparation of the statement of cash flowsprovides a basic introduction to the concepts involved. A complete and detailed presentationof the statement of cash flows is found in Chapter 23 of the text.



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Usefulness of the Statement of Cash Flows

22. (L.O. 7) Creditors look for answers to the following questions in the companys cash fstatement:

a. How successful is the company in generating net cash provided by operating activitie

b. What are the trends in net cash flow provided by operating activities over time?

c. What are the major reasons for the positive or negative net cash provided by operaactivities?

Financial Liquidity

23. The current cash debt coverage ratioindicates whether the company can pay ofcurrent liabilities from its operations in a given year.

Net Cash Provided by Operating Activities= Current Cash Debt Coverage Ratio

Average Current Liabilities

Financial Flexibility

24. The cash debt coverage ratiomeasures a companys ability to repay its liabilities frnet cash provided by operating activities.

Net Cash Provided by Operating Activities= Cash Debt Coverage Ratio

Average Total Liabilities

Free Cash Flow

25. Free cash flow is the amount of discretionary cash flow a company has for purchasadditional investments, retiring its debt, purchasing treasury stock, or simply adding toliquidity.

Net Cash Provided byOperating Activities

Capital Expenditures Dividends = Free Cash F

Supplemental Disclosures

26. (S.O. 8) Supplemental disclosures related to contingencies, accounting policcontractual situations, and fair values provide for elaboration or qualification of ite

listed in the balance sheet.

27. A contingency is defined as an existing situation involving uncertainty as to a possgain (gain contingency) or loss (loss contingency) that will ultimately be resolved wone or more future events occur or fail to occur. In short, they are uncertain occurrenthat may have a material effect on financial position.



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28. The methods used to value assets and allocate costs vary considerably among balancesheet accounts. To help users of the financial statements understand and evaluatefinancial statement components and their relationships, these valuation methods arenormally disclosed in a separate Summary of Significant Accounting Policies precedingthe financial statement notes. In addition to contingencies and valuation methods, anycontractual situations of significance should be disclosed. These items include pensionobligations, lease contracts, stock options, etc.

Fair Values

29. Financial instruments are defined as cash, an ownership interest, or a contractual right toreceive, or an obligation to deliver cash or another financial instrument. Companies are tofollow a fair value hierarchy that provides insight into how to determine fair values. Level 1(the most reliable) measures are based on observable inputs, such as market price foridentical assets or liabilities. Level 2(less reliable) measures are based on market-basedinputs other than those included in Level 1, such as those based on market prices forsimilar assets or liabilities. Level 3(least reliable) measures are based on unobservableinputs, such as a companys own data or assumptions. In addition, companies mustprovide significant additional disclosure related to Level 3 measurements.

Techniques of Disclosure

30. (S.O. 9) Effective communication of the information required to be disclosed in financialstatements is an important consideration. Accountants have developed certain methodsthat have proven useful in disclosing pertinent information. The methods are parentheticalexplanations, notes, cross reference and contra items, and supporting schedules.Numerous examples of the techniques of disclosure are presented in the text.

Terminology

31. The balance sheet should contain descriptive labels that readers will generallyunderstand and clearly interpret. The profession has recommended that companies usethe work reserve only to describe an appropriation of retained earnings. In addition, theprofession has recommended that the use of the work surplus be discontinued in theequity section of the balance sheet.

Ratio Analysis

32. (S.O. 10) Appendix 5A Ratio Analysis.Demonstrates various ratios used to analyzefinancial performance.



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*J. (L.O. 10)APPENDIX 5-A. Ratio Analysis.

1. Used to express the relationships between selected financial statement data.

2. Can be classified as:

a. Liquidity ratios.Measures the companys short-term ability to pay its matuobligations.

b. Activity ratios. Measures how effective a company uses its assets.

c. Profitability ratios. Measures the success or failure of a company.

d. Coverage ratios. Measures the degree of protection for long-term creditors investors.

Students:

Use Illustration 5-6regarding the specific ratios included in each classification.

*K. APPENDIX 5-B. Specimen financial statements.

Students:

Use the questions in Illustrations 5-7 and 5-8 to review the financial statements of TProcter & Gamble Company.

*L. (L.O. 11) IFRS Insights

1. As in GAAP, the balance sheet and the statement of cash flows are requstatements for IFRS. In addition, the content and presentation of an IFRS balansheet and cash flow statement are similar to those used for GAAP. In general, disclosure requirements related to the balance sheet and the statement of cash floare much more extensive and detailed in the United States. IAS 1, PresentatioFinancial Statements, provides the overall IFRS requirements for balance shinformation. IAS 7,Cash Flow Statements, provides the overall IFRS requirementscash flow information. IFRS insights on the statement of cash flows are presentedChapter 23.

2. Relevant Facts

a. Similarities

(1) Both IFRS and GAAP allow the use of title balance sheet or statemenfinancial position. IFRS recommends but does not require the use of the statement of financial position rather than balance sheet.

(2) Both IFRS and GAAP require disclosures about (1) accounting policfollowed, (2) judgments that management has made in the process



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applying the entitys accounting policies, and (3) the key assumptions andestimation uncertainty that could result in a material adjustment to thecarrying amounts of assets and liabilities within the next financial year.Comparative prior period information must be presented and financialstatements must be prepared annually.

(3) IFRS and GAAP require presentation of noncontrolling interests in the equitysection of the balance sheet.

b. Differences

(1) IFRS requires a classified statement of financial position except in very limitedsituations. IFRS follows the same guidelines as this textbook fordistinguishing between current and noncurrent assets and liabilities. Howeverunder GAAP, public companies must follow SEC regulations, which requirespecific line items. In addition, specific GAAP mandates certain forms ofreporting this information.

(2) Under IFRS, current assets are usually listed in the reverse order of liquidity.

For example, under GAAP cash is listed first, but under IFRS it is listed last.

(3) IFRS has many differences in terminology that you will notice in this textbook.

(4) Use of the term reserve is discouraged in GAAP, but there is no suchprohibition inIFRS.



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ILLUSTRATION 5-1BALANCE SHEET CLASSIFICATIONS



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LLUSTRATION 5-2CURRENT ASSET CLASSIFICATION



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ILLUSTRATION 5-3STATEMENT OF CASH FLOWS



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LLUSTRATION 5-4STATEMENT OF CASH FLOWS (INDIRECT METHOD)



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LLUSTRATION 5-6RATIOS



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ILLUSTRATION 5-7QUESTIONS COVERING THE FINANCIAL STATEMENTSOF THE PROCTER & GAMBLE COMPANY



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LLUSTRATION 5-7 (continued)



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ILLUSTRATION 5-8ANSWERS TO QUESTIONS ABOUT THE FINANCIALSTATEMENTS OF THE PROCTER & GAMBLE COMPANY



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LLUSTRATION 5-8 (continued)



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ILLUSTRATION 5-8 (continued)

Copyright 2013 John Wiley & Sons Inc Ki eso Intermediate Accounting 15e Instructors Manual ( For Instructor Use Only)

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ACCT550 Ch 5 Summary for Students