MGT 220 Chapter 5

Balance Sheet: Usefulness• Displays the assets, liabilities and equity of the firm• The balance sheet provides information for

evaluating the capital structure/financial risk of the firm

• The balance sheet in conjunction with the income statement provides information useful in analyzing the firm’s:– financial performance – short-term liquidity (ability to pay current liabilities)– solvency (ability to pay interest and debt, as it matures)

Balance Sheet: Limitations1 Most assets and liabilities are stated at historical cost.

– information presented is reliable, however– reporting at current fair value may result in more

relevant information2 Judgements and estimates are used in determining

many of the items reported. “soft” numbers (estimates) less reliable than “hard” numbers. (e.g., how much receivables will we collect, is inventory obsolete, useful lives of long-term assets)

3 The balance sheet does not report items that can not be objectively determined (e.g., the ‘value’ of experienced staff).

Balance Sheet: Classification

• Current Assets• Long-term

investments• Property, plant, and

equipment• Intangible assets• Other assets

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

– Capital stock– Additional paid-in

capital– Retained earnings

Assets Liabilities and Equity

Current Assets• Current assets are expected to be consumed, sold, or

converted into cash:– either in one year or– in the normal operating cycle, whichever is longer.

• They are presented in order of liquidity• Intent and marketability are important considerations in

classifying certain assets as current (e.g., marketable equity securities).

• The following valuation principles are used:– short-term investments at fair value– accounts receivable at net realizable value

Current Assets - Cash

• Includes cash and cash equivalents• Defined as:

– cash– demand deposits– short-term, liquid investments readily convertible to a

known cash amount, and not subject to material value changes

• Any known restrictions to cash must be disclosed

Current Assets - Receivables

• Amounts should be reported separately based on the nature of their origin:– ordinary trade accounts– amounts owing by related parties– other (material) unusual items

• Separate disclosure required for:– anticipated losses (uncollectibles)– amount and nature of non-trade receivables– receivables pledged as collateral

Current Assets - Inventories

• Valuation basis (lower of cost or market) disclosed

• Method of pricing (FIFO or LIFO) disclosed• Manufacturing enterprise will disclose completion

stage of inventories– raw materials– work in progress– finished goods

Current Assets – Prepaid Expenses

• Defined as: expenditures already made for benefits to be received within one year or within the operating cycle

• Most common examples include– insurance– rent– advertising– supplies

• Current practice is to report some prepaid amounts where the benefit extends beyond one year (or operating cycle)

Long-Term Investments

• Four common types of Long-Term Investments:– investments in securities – investments in tangible fixed assets not used in current operations– investments set aside in special funds for specific purposes– investments in non-consolidated subsidiaries or affiliated companies

• The intent of these investments is that they are: - held for an extended period of time - reported at cost or amortized cost - only adjusted to current value if there is a non-temporary decline in value

Property, Plant and Equipment

• Physical (tangible) assets used in the regular operations of the business to generate revenue

• Disclosure requirements include:– basis of valuation– nature of any liens held against the asset– accumulated amortization

Intangible Assets• Those assets without physical substance, held to generate

revenue• High degree of uncertainty regarding future benefits• Subject to arbitrary write-downs or write-offs due to

valuation/measurement difficulties• Include (most common):

– Patents– Copyrights– Franchises– Goodwill– Trademarks, and trade names

Classifying Assets Can Be TrickyClassification of assets depends on both the nature of the item and use to which it is put. For example:(1) Land used as factory site—classify as property, plant and equipment. (2) Land owned by a realty company and held for sale—classify as current asset.(3) Land held for speculation—classify as long-term investment.(4) Idle land and facilities that have been withdrawn from production—classify as other assets.

Current Liabilities

• Current liabilities are liquidated:– either through the use of current assets, or– by creation of other current liabilities

• Examples of current liabilities include:– payables resulting from acquisitions of goods and

services– collections received in advance of services– other liabilities which will be paid in the short term

Working Capital

Current – Current = Working Assets Liabilities Capital

• A key indicator of the company’s short-term liquidity

• Not usually disclosed on the balance sheet• Often calculated by creditors

Long-term Liabilities

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

• Long-term means “non-current”• Examples are:

– obligations arising from specific financing situations– obligations arising from ordinary business operations – obligations that are contingent

– Balance sheet presentation requires reporting that portion due within the next year as a current liability

Owners’ Equity

• Capital Shares– Number of authorized and issued shares– Outstanding amounts

• Contributed Surplus– Usually reported as one amount– Includes issued share premiums

Owners’ Equity

• Retained Earnings – Presented as one amount– Reacquired (treasury) shares reported as a

reduction of shareholders’ equity• Accumulated Other Comprehensive Income

– Other income items such as: unrealized security gains, certain related party transactions, donations

Balance Sheet: Additional Information Reported

• Additional information may be:- information not presented elsewhere, or- information that qualifies items in the balance sheet

• Five main types of additional information:1. Contingencies2. Accounting policies3. Contractual situations4. Additional detail5. Subsequent events

Contingencies• Events that involve uncertainty as to possible gain

(gain contingency) or loss (loss contingency) that will ultimately be resolved by a future event.

• Examples of gain contingencies are operating loss-carryforwards, or company litigation against a third party.

• Typical loss contingencies relate to litigation, environmental issues, possible tax assessments or government investigation.

ContingenciesGain• do not disclose unless probability of receipt

is highly likely

Loss• likely and amount estimable? Accrue• likely, but not estimable? Note• unlikely? disclosure not necessary

Accounting Policies• CICA Handbook, Section 1505, recommends

description of all significant accounting principles and methods that involve selection from among alternatives and/or those that are peculiar to a given industry be disclosed.

• This disclosure is usually given in the first note or in a separate Summary of Significant Accounting Policies preceding the notes.

Contractual Situations• It is mandatory that essential provisions of

lease contracts, pension obligations, and stock option plans be clearly stated in the notes to the financial statements.

Balance Sheet: Techniques of Disclosure

1 Parenthetical explanations (following the items in the balance sheet)

2 Notes (to the balance sheet)3 Cross references and contra items (where assets

and liabilities may be cross-referenced)4 Supporting schedules (as for fixed assets

depreciation)

Subsequent Events

1. New information relating to existing condition? Adjust

2. Relates to condition not existing at B/S date? Disclose

3. Not an accounting event? Disclosure not required