Measuring Financial Condition:

The Balance Sheet

Chapter 2

Section 2.2Section 2.2

How Financial Statements are Prepared?

Section 2.1

Why one must know the accounting process:1.Accounting has a peculiar technical knowledge that an analyst needs to understand.2.Financial statements are interrelated.3.Double-entry accounting ensures that recording affects two or more accounts.4.Accounting data may not be available to users in a timely way.5.Accounting involves management estimates.

Basic Accounting RulesThe set of accounting records is called books of

account.The process of recording transactions and classifying

them into accounts is called bookkeeping.Rules of recording transactions are based on the

double-entry system in accounting, called the debit-credit mechanism. To debit an account means to record a transaction on the left hand side of an account while to credit an account means to record a transaction on the right hand side of an account.

Accounting CycleRefers to the sequence of steps leading to the

preparation of financial statements. These steps are:

1.Analysis of transaction.2.Recording the transaction in a journal using

debit-credit mechanism.3.Summarizing transactions in accounts.4.Preparation of adjusting entries.5.Preparation of financial statements.

Accounting StandardsAccounting standards in the Philippines are

adopted by the Philippines Financial Reporting Standards Council (PFRSC) and approved by the Securities and Exchange Commission (SEC). The PFRSC has formed the Philippine Interpretations Committee (PIC), which issues implementation guidance on PFRSs.

Balance Sheet (Statement of Financial Position)

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Basic Accounting Equation7

Assets = Liabilities + Stockholders’ Equity

Economic resources

Economic obligations Net assets

It is a company’s statement of financial condition AS OF A GIVEN DATE.

Elements of the Balance Sheet: Assets

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Assets are probable future economic benefits obtained or controlled by a

company as a result of past transactions or events.

Assets: should provide future economic benefits to the company

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Classification of Assets

1. Tangible/Intangible– Tangible assets- resources that

have physical or monetary existence. – Intangible assets- rights acquired

by the company representing access to resources that could generate future income.

Examples: Trademarks, Public Utility Franchise, A Mining Claim, and A Banking

License.

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Intangible Assets11

Intangible assets are those noncurrent economic resources that a company uses in its operations but

have no physical existence.

Patents Copyrights Franchises

Intangible Assets12

Intangible assets are those noncurrent economic resources that a company uses in its operations but

have no physical existence.

Trademarks

® a registered trademark Computer

software costs Goodwill

Classification of Assets

2. Financial/PhysicalPhysical assets- factories,

machinery, buildings, inventory and other properties used in the business.

Financial/Monetary assets- cash and claims by the company against others.

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Classification of Assets

3. Fixed/CurrentFixed assets- used in the

operation of the business and have economic lives longer than one year.

Current assets- resources that can be converted to cash in the normal course of business.

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Current Assets15

Current assets are cash and other assets that are expected to be converted into cash, sold, or

consumed within one year or the normal operating cycle,

whichever is longer.

Operating Cycle16

An operating cycle is the average time taken by a company to spend

cash for inventory,...

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…process and sell the inventory, and collect the receivables,

converting them back into cash.

Operating Cycle

Steps in Operating Cycle18

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Current Assets

Cash includes cash on hand and readily available in checking

and savings accounts.

Cash equivalents are risk-free securities, such as money market funds and treasury bills that

will mature in three months or less from the

date acquired by the holder.

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Current Assets

Temporary investments in marketable securities include debt and equity

securities that are classified as “trading securities,”

“available-for-sale securities,” and “held-to-

maturity” securities.

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Receivables include accounts receivable and notes receivable with short-term maturity dates.

They are listed at their estimated collectible amounts (net realizable values).

Inventories include goods held for resale in the normal course of business plus, in the case of a

manufacturing company, raw materials and work in process inventories.

Prepaid items such as insurance, rent, office supplies, and taxes will not be converted into cash

but will be consumed.

Current Assets

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Other AssetsOther Assets

The Other Assets section occasionally is used to report

miscellaneous assets that may not be readily classified

within one of the previous sections.

Sometimes referred to as “deferred charges”

Long-Term Investments23

Investment items that management expects to hold for more than one year or the

operating cycle, whichever is longer, are classified as long-term (noncurrent)

investments.

Property, Plant, and Equipment24

Property, plant, and equipment includes the tangible assets used in the firm’s operations.

Also called Also called fixed fixed assetsassets

Elements of the Balance Sheet: Liabilities

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Liabilities are probable future sacrifices of economic benefits

arising from present obligations...

Elements of the Balance Sheet: Liabilities

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…of a company to transfer assets or provide services in the future as a

result of past transactions or events.

Current Liabilities27

1. Obligations for items are in the operating cycle (accounts payable and salaries payable).

2. Advance collections for the future delivery of goods or performances of service (unearned rent and unearned ticket sales).

3. Other obligations that will be paid within one year or the operating cycle (the estimated liability for short-term product warranties).

Long-Term Liabilities28

Long-term liabilities are those obligations of a company whose

liquidation is not expected to require the use of current assets or

not expected to create current liabilities within one year or the

normal operating cycle (whichever is longer).

Other Liabilities29

Deferred tax liabilities and obligations of a component of the

company that is being discontinued are examples of

items that might be included as other liabilities.

Elements of the Balance Sheet: Stockholders’ Equity

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Assets = Liabilities + Stockholders’ Equity

Equity is the residual interest in the assets of a

company that remains after deducting its liabilities.

Stockholders’ Equity31

Stockholders’ equity is the residual interest of the stockholders in the

assets of the corporation.

A sole proprietorship is a single-owner

company.

Stockholders’ Equity32

Stockholders’ equity is the residual interest of the stockholders in the

assets of the corporation.

A partnership involves two or more persons who have

agreed to combine their capital and efforts in the operations of a company.

Stockholders’ Equity33

Stockholders’ equity is the residual interest of the stockholders in the

assets of the corporation. The corporation is a

complex business organization. Usually there is

absentee ownership.

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Stockholders’ Equity

Legal capital is the minimum amount of

stockholders’ equity that the corporation may not distribute as dividends.

Preferred stock receives preference

in declared dividends.

Common stock carries the right to vote

at the annual stockholders’ meeting

and to share in residual profits.

Contributed CapitalContributed Capital

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Stockholders’ Equity

Retained earnings is the total amount of corporate net income that has not been

distributed to stockholders as dividends.

Uses of net incomeUses of net incomeTo use in daily operationsTo maintain its productive facilitiesFor growth

Summary of Accounting Policies

A selection from existing acceptable alternatives Principles and methods peculiar to the industry

in which the company operates Unusual or innovative applications of GAAP

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GAAP requires that a company must include a description of all its significant accounting policies as an integral part of its financial

statements.In particular, when these principles and methods involve:

Subsequent Events37

A subsequent event is one that occurs between a company’s balance sheet date and

the date of issuance of the annual report.

End of Accounting Period

Annual Report Publication Date

Subsequent Events

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Report FormReport Form

Assetsxxxx $xxxxxxx xxxTotal assets $xxx

Liabilities and Stockholders’ Equityxxxx $xxxxxxx xxxTotal liabilities and stockholders’ equity $xxx

Balance Sheet Formats

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Liabilities and Stockholders’ Equityxxxx $xxxxxxx xxxTotal liab. & stock. eq. $xxx

Account FormAccount Form

Assetsxxxx $xxxxxxx xxxTotal assets $xxx

Balance Sheet Formats

Limitations of the Balance Sheet

The use of historical cost to value assets and liabilities does not help users assess the likely amounts of future cash flows.

“Human resources” such as high-quality management or highly creative employees are not included as assets.

Many of the amounts that a company reports are based on estimates.

In periods of inflation, some amounts listed do not show the “purchasing power” of assets and liabilities.

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Usefulness of Book Values

Chapter 2

Section 2.3Section 2.3

A balance sheet measures a company’s value, called

BOOK VALUE.

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APPRAISED VALUE

an estimate by professional appraisers of the current value of a

fixed asset.

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Neither cost nor appraised value is consistent with the measurement of value

in managerial finance.

A finance manager would like to know the selling price of an asset or the future income that the asset will generate.

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The cash realized from the sale of an asset rather than its book value represents the recovery of investment.

Another way to realize the investment’s benefits is to use the asset profitability.

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The book value of the asset at the end of period is defined

as:

Book Value= Original Cost – Accumulated

Depreciation

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Accumulated Depreciation

Is the sum of periodic depreciation up to the period.

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Market Values

Refer to current and future values and opportunities.

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Book Value: The Entire Business

The book value of the company is the total book value of assets less the total liabilities of the business.

Book value of owner’s equity= Book value of assets- Book value

of liabilities

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