understanding financial statements eighth edition

Understanding Understanding Financial Statements Financial Statements

EIGHTH EDITIONEIGHTH EDITION

Lyn M. Fraser Lyn M. Fraser

Aileen OrmistonAileen Ormiston

(C) 2007 Prentice Hall, Inc.(C) 2007 Prentice Hall, Inc.

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The Balance SheetThe Balance Sheet

“Old accountants never die; they just lose their balance”

--Anonymous


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The Balance SheetThe Balance Sheet

Also called the statement of Also called the statement of condition or statement of condition or statement of financial positionfinancial position

Shows the financial condition or Shows the financial condition or financial position of a company financial position of a company on a particular dateon a particular date

Financial ConditionFinancial Condition


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Financial Condition Financial Condition (cont.)(cont.)

Assets =Assets = What the firm What the firm ownsowns

Liabilities =Liabilities = What the firm What the firm owesowes to outsiders to outsiders

Stockholders’ equity =Stockholders’ equity = What the firm What the firm owesowes to to

Internal owners Internal owners

Liabilities + Stockholders’ equityLiabilities + Stockholders’ equityAssets =Assets =


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General ParametersGeneral Parameters Consolidation Consolidation – when financial – when financial

statements are combined due to statements are combined due to parent owning more than 50% of parent owning more than 50% of voting stock in subsidiaryvoting stock in subsidiary

Balance Sheet DateBalance Sheet Date prepared at a point in time/on a prepared at a point in time/on a

particular date at end of accounting particular date at end of accounting periodperiod

end of accounting period date can be end of accounting period date can be calendar year or fiscal year or interim calendar year or fiscal year or interim period such as year, quarter, etc.period such as year, quarter, etc.


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General Parameters General Parameters (cont.)(cont.)

Comparative DataComparative Data SEC requires that Balance Sheet SEC requires that Balance Sheet

includes two years of data includes two years of data (current and prior year balances)(current and prior year balances)

Provides reference point for Provides reference point for determining changes in financial determining changes in financial position over timeposition over time


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General Parameters General Parameters (cont.)(cont.)

Common-Size balance sheetCommon-Size balance sheet useful tool for analyzing the balance useful tool for analyzing the balance

sheetsheet expresses each item on the balance expresses each item on the balance

sheet as a percentage of total assetssheet as a percentage of total assets form of vertical ratio analysis that form of vertical ratio analysis that

allows comparison of firms allows comparison of firms regardless of sizeregardless of size

useful for evaluating trends within a useful for evaluating trends within a firm and to make industry firm and to make industry comparisonscomparisons


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Common-Size balance sheet Common-Size balance sheet (cont.)(cont.) Comparison of two major retail Comparison of two major retail companies*companies*

Comparison using $ ($ are in millions):Comparison using $ ($ are in millions): Retailer ARetailer A Retailer BRetailer BCash Cash $ 5,488 $ 5,488 $ 2,245$ 2,245A/RA/R 1,715 1,715 5,069 5,069InventoriesInventories 29,447 29,447 5,384 5,384Current Assets 38,491Current Assets 38,491 13,922 13,922PPE, netPPE, net 65,408 65,408 16,860 16,860 Total AssetsTotal Assets 120,223120,223 32,293 32,293

*Data from SEC website, *Data from SEC website, www.sec.govwww.sec.gov


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Common-Size balance sheetCommon-Size balance sheet (cont.)(cont.) Comparison of two major retail Comparison of two major retail companies*companies*Comparison using common size balance sheet %:Comparison using common size balance sheet %: Retailer ARetailer A Retailer BRetailer BCash Cash 4.56 4.56 6.95 6.95 A/RA/R 1.43 1.43 15.70 15.70InventoriesInventories 24.49 24.49 16.67 16.67 Current Assets 32.02 43.11 Current Assets 32.02 43.11 PPE, netPPE, net 54.4154.41 52.21 52.21



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Assets Assets Generally presented in order of liquidityGenerally presented in order of liquidity

Common Balance Sheet Common Balance Sheet Accounts/GroupingsAccounts/Groupings

Current AssetsCurrent Assets Cash and Marketable SecuritiesCash and Marketable Securities Accounts ReceivableAccounts Receivable InventoriesInventories Prepaid ExpensesPrepaid Expenses

Long-Term AssetsLong-Term Assets Property, Plant, and EquipmentProperty, Plant, and Equipment Other AssetsOther Assets


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A Few DefinitionsA Few Definitions

Current Assets-Current Assets-Cash or other assets Cash or other assets expected to be converted into expected to be converted into cash within one year or one cash within one year or one operating cycle, whichever is operating cycle, whichever is longerlonger

OperatingOperating Cycle-Cycle-Time required to Time required to purchase or manufacture purchase or manufacture inventory, sell the product, and inventory, sell the product, and collect the cashcollect the cash


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A Few Definitions A Few Definitions (cont.)(cont.)

Working CapitalWorking Capital (Net working (Net working capital)—designates the capital)—designates the amount by which current assets amount by which current assets exceed current liabilitiesexceed current liabilities


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Cash Cash and Marketable Securitiesand Marketable Securities

Two accounts are often combined as Two accounts are often combined as ““Cash and Cash Equivalents”Cash and Cash Equivalents”

Cash in any form—cash awaiting Cash in any form—cash awaiting deposit or in a bank accountdeposit or in a bank account

Generally includes currency, coin, Generally includes currency, coin, balances in checking and other balances in checking and other demand or “near demand” accounts demand or “near demand” accounts

CashCash


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Cash Cash and Marketable Securities and Marketable Securities (cont.)(cont.) Also called “Also called “short-term investmentsshort-term investments”” Are cash substitutesAre cash substitutes Represent cash not needed Represent cash not needed

immediately in the businessimmediately in the business Temporarily invested to earn a returnTemporarily invested to earn a return Have short-term maturitiesHave short-term maturities May include T-bills, certificates, May include T-bills, certificates,

notes, bonds, CD’s and commercial notes, bonds, CD’s and commercial paperpaper

Marketable SecuritiesMarketable Securities


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Statement of Financial Statement of Financial Accounting Standards No. Accounting Standards No. 115115Effective for fiscal years beginning Effective for fiscal years beginning

after December 15, 1993after December 15, 1993

Requires the separation of Requires the separation of investment securities into three investment securities into three categories:categories:

1.1. Held to maturity Held to maturity

2.2. Trading securities Trading securities

3.3. Securities available for sale Securities available for sale


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Statement of Financial Statement of Financial Accounting Standards No. 115 Accounting Standards No. 115 (cont.)(cont.)

Applies to debt securities that the Applies to debt securities that the firm has the positive intent and firm has the positive intent and ability to hold to maturityability to hold to maturity

Reported at amortized cost Reported at amortized cost

Held to MaturityHeld to Maturity


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Debt and equity securities that are Debt and equity securities that are held for resale in the short termheld for resale in the short term

Reported at fair value with Reported at fair value with unrealized gains and losses unrealized gains and losses included in earnings included in earnings

Trading SecuritiesTrading Securities


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Debt and equity securities that are Debt and equity securities that are not classified as one of the other not classified as one of the other two categoriestwo categories

Reported at fair value with Reported at fair value with unrealized gains or losses unrealized gains or losses included in comprehensive included in comprehensive income income

Securities Available for SaleSecurities Available for Sale


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Does not apply to investments in Does not apply to investments in consolidated subsidiaries nor to consolidated subsidiaries nor to investments in equity securities investments in equity securities accounted for under the equity accounted for under the equity methodmethod


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Accounts ReceivableAccounts ReceivableArise from sales transactions to Arise from sales transactions to

customers on creditcustomers on credit

Reported on the balance sheet at Reported on the balance sheet at

NET REALIZABLE VALUENET REALIZABLE VALUE

- Allowance for Doubtful - Allowance for Doubtful AccountsAccounts

Net Realizable Value =Net Realizable Value =Accounts ReceivableAccounts Receivable


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A Word on the A Word on the “Allowance…”“Allowance…” Management must estimate the dollar Management must estimate the dollar

amount of accounts receivable they amount of accounts receivable they expect to be uncollectible expect to be uncollectible

Affects balance sheet valuation AND Affects balance sheet valuation AND bad debt expense on income statementbad debt expense on income statement

Can be important in assessing earnings Can be important in assessing earnings quality--changes should be analyzed quality--changes should be analyzed


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InventoriesInventories

Items held for sale or used in the Items held for sale or used in the manufacture of products that manufacture of products that will be sold will be sold


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Inventories Inventories (cont.)(cont.)

Retail CompanyRetail CompanyOne type of inventory:One type of inventory: Finished goods Finished goods

Manufacturing CompanyManufacturing CompanyThree types of inventories:Three types of inventories:

Raw materialsRaw materials Work-in-process Work-in-process Finished goodsFinished goods


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Inventories Inventories (cont.)(cont.)

Accounting method chosen to value Accounting method chosen to value inventory and the associated inventory and the associated measurement of cost of goods measurement of cost of goods sold have a considerable impact sold have a considerable impact on a company’s financial on a company’s financial position and operating resultsposition and operating results


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Inventory Inventory Accounting MethodsAccounting Methods

Inventory valuation is based on an Inventory valuation is based on an assumptionassumption regarding the flow regarding the flow of goodsof goods

Has nothing to do with the Has nothing to do with the actualactual order in which products are sold order in which products are sold

Cost flow assumption made in order Cost flow assumption made in order to to match match the cost of products the cost of products sold to the revenue generatedsold to the revenue generated


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Inventory Inventory Accounting Methods Accounting Methods (cont.)(cont.)

Three cost flow assumptions:Three cost flow assumptions:

FIFOFIFO ( (FFirst irst IIn, n, FFirst irst OOut)ut)

LIFOLIFO ( (LLast ast IIn, n, FFirst irst OOut)ut)

Average costAverage cost


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Accounting Method

FIFO

LIFO

Average Cost

Cost of Goods Sold(Income Statement)

first purchases

last purchases(close to current cost)

average of all purchases

Inventory Valuation(Balance Sheet)

last purchases(close to current cost)

first purchases

average of all purchases


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Produces the highest COGS expense Produces the highest COGS expense and the lowest ending inventory and the lowest ending inventory valuationvaluation

Matches current costs to current Matches current costs to current salessales

LIFO During Inflation


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Produces the lowest COGS expense Produces the lowest COGS expense and the highest ending inventory and the highest ending inventory valuationvaluation

Values ending inventory at current Values ending inventory at current cost cost

FIFO During InflationFIFO During Inflation


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Inventory Inventory Accounting Methods Accounting Methods (cont.)(cont.)Inventory valuation may significantly Inventory valuation may significantly

affect BOTH the balance sheet and affect BOTH the balance sheet and the income statementthe income statement

Disclosure of inventory cost flow Disclosure of inventory cost flow assumption found in notesassumption found in notes

Inventory reported on balance sheet at Inventory reported on balance sheet at LOWER OF COST OR MARKET LOWER OF COST OR MARKET


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Prepaid ExpensesPrepaid ExpensesRepresent expenses paid in advance-- Represent expenses paid in advance--

included in current assets if they expire included in current assets if they expire within one year or one operating cyclewithin one year or one operating cycle

Usually not a material itemUsually not a material item

Present few or no reporting or valuation Present few or no reporting or valuation issuesissues


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Property, Plant, Property, Plant, and Equipment (PP&E)and Equipment (PP&E)Encompasses a company’s fixed Encompasses a company’s fixed

assetsassets Also called tangible, long-lived, and Also called tangible, long-lived, and

capital assetscapital assets

Fixed assets other than land are Fixed assets other than land are “depreciated” over the period of “depreciated” over the period of time they benefit the firm time they benefit the firm

process of depreciation is method of process of depreciation is method of allocating the cost of long-lived assetsallocating the cost of long-lived assets


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Property, Plant, Property, Plant, and Equipment (PP&E) and Equipment (PP&E) (cont.)(cont.)

On any balance sheet date, PP&E is On any balance sheet date, PP&E is shown at BOOK VALUEshown at BOOK VALUE

Book value = Book value = original cost original cost

- accumulated depreciation to - accumulated depreciation to date date


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Straight lineStraight line spreads the expense spreads the expense evenly by periodsevenly by periods

AcceleratedAccelerated yields higher yields higher depreciation expense in the early years depreciation expense in the early years of an asset’s useful life, and lower of an asset’s useful life, and lower depreciation expense in the later years depreciation expense in the later years

Units of productionUnits of production bases bases depreciation expense for a given period depreciation expense for a given period on actual useon actual use

Depreciation methods:Depreciation methods:


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Proportion of fixed assets (PP&E) in a Proportion of fixed assets (PP&E) in a company’s asset structure company’s asset structure determined by nature of the determined by nature of the businessbusiness

Comparisons between firms can be Comparisons between firms can be difficult due to different difficult due to different depreciation methods and depreciation methods and estimatesestimates


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Other AssetsOther AssetsCan include multitude of other Can include multitude of other

noncurrent items such as:noncurrent items such as: Property held for saleProperty held for sale Start-up costs in connection with a Start-up costs in connection with a

new businessnew business Cash surrender value of life Cash surrender value of life

insurance policiesinsurance policies Long-term advance paymentsLong-term advance payments Long-term investmentsLong-term investments Intangible assets Intangible assets


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Other Assets—IntangibleOther Assets—Intangible

Most important for analytical purposesMost important for analytical purposesbecause of potential materialitybecause of potential materiality

Arises when one company acquires Arises when one company acquires another company for a price in another company for a price in excess of the fair market value of excess of the fair market value of the net identifiable assets acquired the net identifiable assets acquired

GoodwillGoodwill


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Goodwill Goodwill (cont.)(cont.)

Beginning in 2002, companies Beginning in 2002, companies required to evaluate goodwill required to evaluate goodwill and determine whether it has and determine whether it has lost valuelost value

Amount of impairment is expensed Amount of impairment is expensed in the year the determination is in the year the determination is mademade


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Some corporations take enormous Some corporations take enormous

write-offs when companies they write-offs when companies they have acquired lose value have acquired lose value

Earnings increase for some firms Earnings increase for some firms relative to prior years because relative to prior years because amortization expense is no amortization expense is no longer recorded longer recorded


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Companies have some discretion in Companies have some discretion in deciding when and how much deciding when and how much

write-off to take as a result of write-off to take as a result of goodwill impairment goodwill impairment


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($ in millions)($ in millions)

YearYear GW ImpairmentGW Impairment GW AmortizationGW Amortization

2005 2005 $ 24 $ 24 $ ----$ ----

20042004 10 10 ---- ----

20032003 318 318 ---- ----

20022002 44,03944,039 ---- ----

20012001 ---- ---- 6,366 6,366


Example of the impact the 2002 change for Example of the impact the 2002 change for goodwill expense had on a major goodwill expense had on a major entertainment company over a 5 year entertainment company over a 5 year period * period *


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LiabilitiesLiabilitiesRepresent claims against assets by Represent claims against assets by

creditorscreditors

Current Liabilities must be satisfied in one Current Liabilities must be satisfied in one year or one operating cycle and year or one operating cycle and include:include:

Accounts PayableAccounts Payable Notes PayableNotes Payable Current Portion of Long-Term DebtCurrent Portion of Long-Term Debt Accrued LiabilitiesAccrued Liabilities Unearned Revenue Unearned Revenue Deferred TaxesDeferred Taxes


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Liabilities Liabilities (cont.) (cont.)

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

Account is eliminated when the bill is Account is eliminated when the bill is satisfiedsatisfied

Significant changes from period to Significant changes from period to period often result from changes in period often result from changes in sales volume, economic conditions or sales volume, economic conditions or credit policies available to firm from credit policies available to firm from its suppliers its suppliers

Accounts PayableAccounts Payable


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Short-term obligations in the Short-term obligations in the form of promissory notes form of promissory notes and/or lines of credit to and/or lines of credit to suppliers or financial suppliers or financial institutionsinstitutions

Notes PayableNotes Payable


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When a firm has bonds, mortgages, When a firm has bonds, mortgages, or other forms of long-term or other forms of long-term debt outstanding, the portion of debt outstanding, the portion of the principal that will be repaid the principal that will be repaid during the upcoming year is during the upcoming year is classified as a current liabilityclassified as a current liability

Current Maturities of Long-Term DebtCurrent Maturities of Long-Term Debt


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Liabilities Liabilities (cont.)(cont.)

Result from recognition of expenses Result from recognition of expenses before they are actually paidbefore they are actually paid

Under accrual accounting, expenses Under accrual accounting, expenses are recognized when INCURRED and are recognized when INCURRED and thus ACCRUED, not when paid in thus ACCRUED, not when paid in cashcash

In this case, cash flow In this case, cash flow succeeds succeeds expense recognition expense recognition

Accrued LiabilitiesAccrued Liabilities


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Liabilities Liabilities (cont.)(cont.)

Result from prepayments received Result from prepayments received in advance for services or productsin advance for services or products

Under accrual accounting, revenue Under accrual accounting, revenue is recognized when EARNED, not is recognized when EARNED, not when cash is receivedwhen cash is received

In this case, cash flow In this case, cash flow precedesprecedes revenue recognition revenue recognition

Unearned Revenue or Deferred CreditsUnearned Revenue or Deferred Credits


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Result of temporary differences in Result of temporary differences in the recognition of revenue and the recognition of revenue and expense for taxable income expense for taxable income relative to reported financial relative to reported financial income income

Deferred Federal Income TaxesDeferred Federal Income Taxes


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Deferred Federal Income Deferred Federal Income Taxes Taxes (cont.)(cont.)

Objective is to take advantage of all Objective is to take advantage of all available tax deferrals in order available tax deferrals in order to reduce actual tax payments, to reduce actual tax payments, while showing the highest while showing the highest possible amount of reported possible amount of reported net incomenet income


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Deferred Federal Income Deferred Federal Income Taxes Taxes (cont.)(cont.)

When the total amount of expense When the total amount of expense and revenue recognized will and revenue recognized will eventually be the same for tax eventually be the same for tax and financial reporting and financial reporting purposes purposes

Temporary Differences/Timing Temporary Differences/Timing DifferencesDifferences


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Deferred Federal IncomeDeferred Federal IncomeTaxes Taxes (cont.)(cont.)

Do not affect deferred taxes Do not affect deferred taxes because a tax will never be because a tax will never be paid on the income or the paid on the income or the expense will never be deducted expense will never be deducted on the tax return on the tax return

Permanent DifferencesPermanent Differences


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Noncurrent LiabilitiesNoncurrent Liabilities

Long-Term DebtLong-Term Debt Capital Lease ObligationsCapital Lease Obligations Postretirement Benefits Other Postretirement Benefits Other

Than PensionsThan Pensions Commitments and ContingenciesCommitments and Contingencies Hybrid SecuritiesHybrid Securities

Obligations with maturities beyond one yearObligations with maturities beyond one year


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Noncurrent Liabilities Noncurrent Liabilities (cont.)(cont.)

BondsBonds Long-Term Notes PayableLong-Term Notes Payable MortgagesMortgages Obligations under leasesObligations under leases Pension LiabilitiesPension Liabilities Long-Term WarrantiesLong-Term Warranties

Long-Term DebtLong-Term Debt


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Are, in substance, a “purchase” Are, in substance, a “purchase” rather than a “lease”rather than a “lease”

Affect both balance sheet and Affect both balance sheet and income statementincome statement

Capital Lease ObligationsCapital Lease Obligations


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Can appear under the liability section Can appear under the liability section of the balance sheetof the balance sheet

Can have a significant impact on Can have a significant impact on corporate balance sheetscorporate balance sheets

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

Postretirement benefits Other Than PensionsPostretirement benefits Other Than Pensions


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Intended to draw attention to the Intended to draw attention to the fact that required disclosures fact that required disclosures can be found in the notes to can be found in the notes to the financial statements the financial statements

Commitments and ContingenciesCommitments and Contingencies


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Refer to contractual agreements that will Refer to contractual agreements that will have a significant financial impact on have a significant financial impact on the company in the futurethe company in the future

For example:For example: An An operating leaseoperating lease is a is a common type of commitment and is a common type of commitment and is a form ofform of

off-balance-sheet financingoff-balance-sheet financing

CommitmentsCommitments


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Refer to potential liabilities of the Refer to potential liabilities of the firm such as possible damage firm such as possible damage awards assessed in lawsuitsawards assessed in lawsuits

ContingenciesContingencies


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Have the characteristics of both Have the characteristics of both debt and equitydebt and equity

Some companies have Some companies have mandatorily redeemable mandatorily redeemable preferred stock preferred stock outstanding outstanding

Hybrid SecuritiesHybrid Securities

For example:For example:


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Stockholders’ EquityStockholders’ Equity

Ownership equity is the residual Ownership equity is the residual interest in assets that remains interest in assets that remains after deducting liabilities after deducting liabilities


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Stockholders’ Equity Stockholders’ Equity (cont.)(cont.)

Shareholders:Shareholders:Do not ordinarily receive a fixed returnDo not ordinarily receive a fixed return

Have voting privileges in proportion to Have voting privileges in proportion to ownership interestownership interest

Dividends are declared at the discretion of a Dividends are declared at the discretion of a company’s board of directorscompany’s board of directors

Common StockCommon Stock


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Reflects the amount by which the Reflects the amount by which the original sales price of the stock original sales price of the stock shares exceeded par valueshares exceeded par value

Additional Paid-In CapitalAdditional Paid-In Capital


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Is the sum of every dollar a company has Is the sum of every dollar a company has earned since its inception, less any earned since its inception, less any payments made to shareholders in payments made to shareholders in the form of cash or stock dividendsthe form of cash or stock dividends

Beginning retained earnings Beginning retained earnings ± Net income (loss) – Dividends ± Net income (loss) – Dividends

= Ending retained earnings = Ending retained earnings

Retained EarningsRetained Earnings


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Other accounts that can appear in the Other accounts that can appear in the equity section include:equity section include:

Preferred stockPreferred stockAccumulated other comprehensive Accumulated other comprehensive

incomeincomeTreasury stockTreasury stock

Other Equity AccountsOther Equity Accounts


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Other Balance Sheet Other Balance Sheet ItemsItemsCorporate balance sheets are not limited Corporate balance sheets are not limited

to the accounts described in this to the accounts described in this chapterchapter

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


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The Journey The Journey Through the Maze Through the Maze ContinuesContinues

Ch. 3:Ch. 3: Income Statement and Income Statement and Statement of Stockholders’ EquityStatement of Stockholders’ Equity

Ch. 4:Ch. 4: Statement of Cash FlowsStatement of Cash Flows

Ch. 5:Ch. 5: A Guide to Earnings and Financial A Guide to Earnings and Financial Reporting QualityReporting Quality

Ch. 6:Ch. 6: The Analysis of Financial The Analysis of Financial StatementsStatements

understanding financial statements eighth edition

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