modul-3- the financial statement part ii- balance sheet · pdf filethe financial statement...

MODUL-3

Financial Accounting

The Financial Statement Part II :

Balance SheetBy

MUH. ARIEF EFFENDI,SE,MSI,AK,QIA

Magister Accounting Program (MAKSI)

BUDI LUHUR UNIVERSITY

Jakarta - Indonesia

2010

The Financial Statement Part II :

Balance Sheet

1. Understand the introduction of the Balance Sheet.

2. Understand the equation of the Balance Sheet.

3. Understand the basic of the Balance Sheet.

4. Understand the elements of the Balance Sheet.

5. Understand the relationship between Balance Sheet and Income

Statement.

6. Understanding the usefullness of the Balance Sheet.

7. Understand the limitations of the Balance Sheet.

8. Understand the format of the Balance Sheet.

After studying this topic, students should be able to:

The Balance Sheet : Introduction

Also called the statement of condition or the statement of

financial position.

Shows the financial condition or financial position of a

company on a particular date.

Summarizes what the firm owns and what the firm owes to

outsiders and to internal owners.

Measures wealth at one point in time (usually the end of the

reporting period).

Remains in balance after every transaction.

Snapshot of investing and financing activities at a moment in

time.

The Balance Sheet : Introduction

Balance Sheet Date :1. Prepared on a particular date at the end of an accounting period

2. End of accounting period can be the end of a calendar year, fiscal year, or

interim period such as a year, a quarter, etc.

Comparative Data :

1. Securities Exchange Commission (SEC) requires that the annual report

includes two-year audited balance sheets and three-year audited statements of

income and cash flow.

2. Comparative data provides a reference point for determining changes in

financial position over time.

Common-Size Balance Sheet :

1. Expresses each item on the balance sheet as a percentage of total assets

2. Reveals the composition of assets

3. Form of vertical ratio analysis that allows comparison of firms

4. Useful for evaluating trends within a firm and to make industry comparisons

Define double-entry

accounting

What Is the Accounting Equation?

The Balance Sheet : Equation

The Balance Sheet : Equation - 1

A = L + SEAssets = Liabilities + Shareholders’ Equity

Assets are what the firm owns.

Liabilities are what the firm owes to outsiders.

Stockholders’ Equity is what the firm owes to internal owners.

Assets = Liabilities + Owners’ Equity

Sources of Financing

Creditors’

claims

against

resources

= + Owners’

claims

against

resources

Resources

Resources

to use to

generate

revenues

The Balance Sheet : Equation - 2

The Balance Sheet : The Basics

1. Liquidity—cash or items convertible into cash that can be used to pay

obligations in the near term.

2. Assets—future economic benefits, controlled by an entity, resulting from a

past transaction

3. Current asset—liquid resource; usually converted into cash within one year.

4. Long-term asset—illiquid resource; used to generate revenues and cash

flows; includes long-term investments, property, plant, equipment, and

intangible assets.

5. Liabilities—future economic obligations, owed by an entity, resulting from

a past transaction.

6. Current liabilities—pending obligations; usually payable within one year.

7. Long-term liabilities—non-current obligations.

Sometimes

referred to as a

Statement of

Financial

Position

• What are the resources of

the company?

• What are the company’s

existing obligations?

• What are the company’s

net assets?

Summary of the financial position

of a company at a particular date.Assets: Cash, Marketable Securuties, Accounts Receivable, Inventory, Prepaid Expense, Land, Buildings, Equipment, and Intangible items.

Liabilities: Accounts Payable, Notes Payable, and Mortgages Payable.

Owners’ Equity: Net Assets after all obligations have been satisfied.

Elements of The Balance Sheet

Elements of The Balance Sheet : Asset

Asset : Segregated according to how they are utilized . Current Assets

• Include cash and assets expected to be converted to cash within one year

or one operating cycle

• Refer to assets that are continually used up and replenished• Operating cycle : Time required to purchase or manufacture inventory, sell the

product, and collect the cash

• Working capital : Also called net working capital

Current Assets less Current Liabilities (CA – CL)

Property, Plant, and Equipment

Accumulated depreciation and amortization

Other Assets

Elements of The Balance Sheet : Current Assets

Current Assets

• Include cash and assets expected to be converted to cash within one year

or one operating cycle

• Refer to assets that are continually used up and replenished• Operating cycle : Time required to purchase or manufacture inventory, sell the

product, and collect the cash

• Working capital : Also called net working capital

Current Assets less Current Liabilities (CA – CL)

Elements of The Balance Sheet : Current Assets

1. Cash

2. Marketable Securities

3. Accounts Receivable

4. Inventories

5. Prepaid Expenses

Elements of The Balance Sheet : Cash

Generally any monies available ―on demand.‖

Cash equivalents - short-term highly liquid investments that

mature within three months or less.

Restrictions or commitments must be disclosed.

Cash :

1. Cash awaiting deposit2. Cash in a bank account

Elements of The Balance Sheet :

Marketable Securities

Short-term investments of cash that is not needed U.S. Treasury bills, certificates, notes, bonds,

commercial paper

Valuation of marketable securities requires the

separation of investment securities into three categories :

1. Held to maturity

2. Trading securities

3. Securities available for sale


Marketable Securities

1. Held to maturity Positive intent and ability to hold to maturity. Reported at amortized cost.

2. Trading securities Held for resale in the short term. Reported at fair value with unrealized gains and losses

included in earnings.

3. Securities available for sale

Debt and equity securities that are not classified as one of the

other two categories.

Reported at fair value with unrealized gains or losses

included in comprehensive income .

Portfolios Type Valuation Classification

Held-to-Maturity

DebtAmortized Cost

Current or Noncurrent

Trading Debt or Equity Fair Value Current

Available-for-Sale

Debt or Equity Fair ValueCurrent or Noncurrent

Elements of The Balance Sheet : Marketable Securities -

Short-Term Investments


Account Receivable (AR)

Customer balances outstanding on credit sales.

Reported on the balance sheet at net realizable value (actual

amount less an allowance for doubtful accounts).

Allowance for doubtful accounts :

1. Affect balance sheet valuation and bad debt expense on

income statement

2. Can be important in assessing earnings quality

3. Should reflect volume of credit sales, past experience with

customers, customer base, credit policies, collections

practices, and economic conditions


Inventories

Inventories : Items held for sale or used in the

manufacture of products that will be sold.

1. Retail Company (one type of inventory) Finished goods

2. Manufacturing Company (three types of

inventory) : Raw materials

Work-in-process

Finished goods


Inventories

Method used has a considerable impact on a company’s

financial position and operating results.

Valuation is based on an assumption regarding the flow of

goods, not the actual order in which products are sold.

Cost flow assumption is made in order to match the cost of

products sold to the revenue generated.

Disclosure of inventory cost flow assumption is found in the

notes.

Inventory reported on balance sheet is at the lower of cost or

market.

Inventory Accounting Methods


Inventories

Inventory Accounting Methods :Three cost flow assumptions most frequently used

by the companies :

1. Accounting Method

FIFO (First In First

Out)

LIFO (Last In First

Out)

Average Cost

2. Cost of Goods Sold

(Income Statement)

first purchases

last purchases

(close to current cost)

average of all purchases

3. Inventory Valuation

(Balance Sheet)

last purchases

(close to current cost)

first purchases

average of all purchases


Inventories

LIFO during inflation Produces the highest cost of goods sold expense

and the lowest ending inventory valuation.

Reduces taxes and reported earnings.

Cost of goods sold valued at current cost of

inventory items.

Undervalued inventories on balance sheet.

Inventory Accounting Methods :


Inventories

FIFO during inflation Produces the lowest cost of goods sold

expense and the highest ending inventory valuation.

Increases taxes and reported earnings. Balance sheet inventory valued at current

cost. Undervalued inventories on income

statement.

Inventory Accounting Methods :


Prepaid Expenses

Expenses paid in advance :

1. insurance

2. rent

3. property taxes

4. utilities

Included in current assets if they expire

within one year or one operating cycle.

Generally not material to the balance sheet.


Property, Plant & Equipment (PPE)

Encompasses a company’s fixed assets.

Also called tangible, long-lived, and capital assets.

Not used up during annual operations.

Produce economic benefits for more than one year.

Have physical substance.

Fixed assets other than land are “depreciated”

over the period of time they benefit the firm.



The process of depreciation is a method of

allocating the cost of long-lived assets.

Original cost less estimate residual value is spread

over the asset’s expected life.

On any balance sheet date, PPE is shown at book

value (the difference between original cost and

accumulated depreciation to date).

Several choices and estimates must be made to

determine the annual depreciation expense of an

asset.



Land refers to property used in business, not investment property.

Leasehold investments are additions or improvements made to leased structures.

Construction in progress are the costs of constructing new buildings that are not yet complete.

Equipment represents the original cost of the machinery and equipment used in business operations.

Proportion of fixed assets in a company’s asset structure is determined by nature of the business.

Fixed assets are most prominent at the manufacturing level.



Depreciation Methods

Straight-line method allocates an equal amount of expense to each year of the depreciation period.

Accelerated method apportions larger amounts of expense to earlier years of the asset’s depreciable life.

Units-of-production method bases depreciation expense on actual use.

Elements of The Balance Sheet : Other Assets

Can include many other noncurrent items:

Property held for sale.

Start-up costs in connection with a new

business.

Cash surrender value of life insurance policies.

Long-term advance payments.

Long-term investments.

Intangible assets.


Other Assets - Intangible Assets

Goodwill recognized in business combinations

Patents

Trademarks

Copyrights

Brand Names

Franchises


Other Assets - Intangible Assets

Goodwill : Most important intangible asset for analytical

purposes because of potential materiality. Arises when one company acquires another

company for a price in excess of the fair market value of the net identifiable assets acquired.

Evaluated annually.


Liabilities

Represent claims against assets and include :1. Current Liabilities

Current liabilities must be satisfied in one year or one operating cycle.

Accounts payable, notes payable, current maturities of long-term debt, accrued liabilities, unearned revenue or deferred credits, deferred federal income taxes.

2. Noncurrent liabilities

Long-term debt, capital lease obligations, postretirement benefits other than pensions, commitments and contingencies, hybrid securities.


Current Liabilities – Account Payable

Short-term obligations that arise from credit extended by suppliers for the purchase of goods and services.

Account is eliminated when bill is satisfied.

Increase and decrease depending on credit policies, economic conditions, and cyclical nature of operations.


Current Liabilities – Notes Payable

Short-term obligations in the form of

promissory notes

Lines of credit to suppliers or financial

institutions

Elements of The Balance Sheet : Current Liabilities –

Current Maturities of Long-term Debt

Portion of the principal of long-term

debt that will be repaid during the

upcoming year.


Current Liabilities – Accrued Liabilities

Result from recognition of an expense prior to

actual payment of cash.

Recorded as reserve accounts.

Reserve accounts are :

o set up to estimate obligations for certain

items.

o identified in the notes.


Unearned Revenue or Deferred Credits

Result from payments received in advance for

services or products.

Transferred to a revenue account when service

is performed or product is delivered.


Deferred Federal Income Taxes

Result of temporary differences in the recognition of

revenue and expense for taxable income relative to

reported income.

Intended to take advantage of all available tax deferrals to

reduce actual tax payments, while showing the highest

possible amount of reported net income.

Classified as current or noncurrent on the balance sheet.

Can appear on the balance sheet as a current asset, current

liability, noncurrent asset, or noncurrent liability.


Deferred Federal Income Taxes

Temporary differences can be caused by choice of accounting method for :

1. Depreciation

2. Installment sales

3. Long-term contracts and leases

4. Warranties and service contracts

5. Pensions and other employee benefits

6. Subsidiary investment earnings

Permanent differences in income tax accounting do not affect deferred

taxes and include :

1. Municipal bond revenue

2. Life insurance premiums

A valuation allowance is used to reduce deferred tax assets to expected

realizable amounts when it is determined that it is more likely than not that

some of the deferred tax assets will not be realized.

Elements of The Balance Sheet : Non Current Liabilities -

Long Term Debt

1. Bonds

2. Long-Term Notes Payable

3. Mortgages

4. Obligations under leases

5. Pension Liabilities

6. Long-Term Warranties


Capital Lease Obligations

Are, in substance, a ―purchase‖ rather than a ―lease‖.

Affect both balance sheet and income statement. Disclosures found in the notes, often under both

the property, plant, and equipment note and the commitments and contingencies note.


Postretirement benefits other than pensions

Can appear under the liability section of the balance sheet.

Can have a significant impact on corporate balance sheets.

Can also impact profitability by substantially increasing the recognition of annual postretirement benefit expense.


Commitments and Contingencies

Intended to draw attention to the fact that

required disclosures can be found in the notes

to the financial statements.

Commitments refer to contractual agreements

that will have a significant financial impact on

the company in the future.

Contingencies refer to potential liabilities of

the firm such as possible damage awards

assessed in lawsuits.


Hybrid Securities

Have the characteristics of both debt and equity

Also called mandatorily redeemable preferred

stock

Financial instrument is preferred stock, but the

issuing company must retire the shares at a

future date.


Stockholders’ Equity

Final section of balance sheet

Also called shareholders’ equity

Residual interest in assets that remains after

deducting liabilities

Owners bear greatest risk and benefit from

greatest rewards.


Stockholders’ Equity - Common Stock

Shareholders :

o do not ordinarily receive a fixed return.

o have voting privileges in proportion to

ownership interest.

o can benefit through price appreciation.

o can suffer through price depreciation.

Dividends are declared at the discretion of a

company’s board of directors.


Stockholders’ Equity - Additional Paid-in Capital

Reflects the amount by which the original sales

price of the stock shares exceeded par value


Stockholders’ Equity - Retained Earnings

Sum of every dollar a company has earned

since its inception, less any payments made to

shareholders.

Funds a company has elected to reinvest in the

operations of the business rather than pay out

in stock.

Measurement of all undistributed earnings.

Key link between income statement and

balance sheet.


Stockholders’ Equity - Other Equity Accounts

1. Preferred stock :

Carries a fixed annual dividend payments.

Carries no voting rights.

2. Accumulated other comprehensive income : Unrealized gains or losses in the market value of

investments in available-for-sale securities. Any change in the excess of additional pension liability

over unrecognized prior service cost. Certain gains and losses on derivative financial instruments. Foreign currency translation adjustments resulting from

converting financial statements from a foreign currency into U.S. dollars.

3. Treasury stock.


Other Balance Sheet Items

Corporate balance sheets are not limited to the accounts described in this chapter.

The reader of annual reports will encounter additional accounts and will also find many of the same accounts listed under a variety of different titles.

The Relationship Between Balance Sheet and

Income Statement

The income statement links the balance sheet at

the beginning of the period with the balance sheet

at the end of the period.

Retained Earnings is increased by net income and

decreased by dividends.

The Usefullness of The Balance Sheet

1. Evaluating the capital structure.

2. Assess risk and future cash flows.

3. Analyze the company’s:

Liquidity,

Solvency, and

Financial flexibility.

The Limitations of The Balance Sheet

Most assets and liabilities are

reported at historical cost.

Use of judgments and estimates.

Many items of financial value are

omitted.

The Format of The Balance Sheet

The Format (Classified) Balance Sheet :

1. Account form

2. Report form

Accounting Trends and Techniques—2007 (New

York: AICPA) indicates that all of the 600 companies

surveyed use either the “report form” (524) or the

“account form” (76), sometimes collectively referred

to as the “customary form.”

The Format of The Balance Sheet :

Account Form

Source : Kieso, Weygandt & Warfield, Intermediate Accounting, John Wiley & Sons, Inc, 13Ed, 2009

The Format of The Balance Sheet :

Report Form

Source : Kieso, Weygandt & Warfield, Intermediate Accounting, John Wiley & Sons, Inc, 13Ed, 2009

REFERENCES

1. American Institute of Certified Public Accountants (AICPA), http://www.aicpa.org

2. Financial Accounting Standard Board (FASB), http://www.fasb.org

3. Fraser , Lyn M. & Aileen Ormiston , Understanding Financial Statements, Pearson Education Inc, Ninth Edition, 2010.

4. International Financial Reporting Standard (IFRS), http://www.ifrs.org

5. Kieso, Donald E., Jerry J. Weygandt & Terry D. Warfield, Intermediate Accounting, John Wiley & Sons, Inc, 13Ed, 2009

http://www.aicpa.org/

http://www.fasb.org/

http://www.ifrs.org/

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