3 Days of Accounting :D.. Wednesday AM Introduction Wednesday PM Income Statement Thursday AM Balance Sheet Thursday PM Cash Flow Statement Friday AM Practical Exam & Conclusion

The Balance Sheet Also called the statement of condition or the statement of financial position Shows the financial condition of a company on a particular date Summarizes what the firms owns and what the firm owes to outsiders and to internal owners 2-2

Financial Condition Assets are what the firm owns. Liabilities are what the firm owes to outsiders. Stockholders’ equity is what the firm owes to internal owners. 2-3

Financial Condition Consolidation Parent company owns more than 50% of voting stock. Financial statements are combined. 2-4

Financial Condition Balance Sheet Date The date the balance sheet is prepared Could be the end of the calendar year, fiscal year, quarter, etc. 2-5

Financial Condition Comparative Data SEC requires two-year audited balance sheets. Provides a reference point for determining changes in financial position 2-6

Common-Size Balance Sheet Financial Condition Common-Size Balance Sheet Expresses each item on the balance sheet as a percentage of total assets Reveals the composition of assets Form of vertical ratio analysis Useful for evaluating trends within a firm Allows for making industry comparisons 2-7

Financial Condition 2-8

Assets 2-9

Assets The allowance account for Sage Inc. represents approximately 5% of accounts receivable: 2-10

Assets Sage Inc. 2-11

Assets 2-12

Assets 2-13

Assets 2-14

Assets Example – A new company in its first year of operations purchases five products for sale in the order and at the prices shown. The company sells three of these items at the end of the year. Item Purchase Price #1 $5 #2 $7 #3 $8 #4 $9 #5 $11 2-15

Assets Cost flow assumptions Resulting effect on the income statement and balance sheet 2-16

Assets Current Assets – Prepaid Expenses Expenses paid in advance Insurance Rent Property taxes Utilities Included in current assets if they expire within one year or one operating cycle Generally not material to the balance sheet 2-17

Assets Property, Plant, and Equipment (PP&E) Encompasses a company’s fixed assets Not used up during annual operations Produce economic benefits for more than one year Have physical substance Shown at book value on the balance sheet 2-18

Assets Property, Plant, and Equipment (PP&E) The relative proportion of fixed assets in a company’s asset structure will largely be determined by the nature of the business. Manufacturing firms typically have higher percentages of fixed assets than retailers or wholesalers. Firms with newly purchased assets will have higher percentages of fixed assets than firms with older fixed assets. 2-19

Assets Example – Assume that Sage Inc. purchases an artificial ski mountain for its Phoenix flagship store in order to demonstrate skis and allow prospective customers to test-run skis on a simulated course. The cost of the mountain is $50,000 and is expected to have a five-year useful life and $0 salvage value at the end of that period. 2-20

Assets 2-21

Assets 2-22

Liabilities Represent claims against assets Current liabilities Must be satisfied in one year or one operating cycle Noncurrent liabilities Obligations with maturities beyond one year 2-23

Liabilities 2-24

Liabilities Current Liabilities – Accrued Liabilities Example – Assume that a company has a $100,000 note outstanding with 12% interest due in semiannual installments on March 31 and September 30. For a balance sheet prepared on December 31, interest will be accrued for three months (October, November, and December). The December 31 balance sheet would include an accrued liability of $3,000: $100,000 x 0.12 = $12,000 annual interest $12,000/12 = $1,000 monthly interest $1,000 x 3 = $3,000 accrued interest for three months 2-25

Liabilities Deferred Taxes Result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income Depreciation methods are the most common source for temporary differences. 2-26

Liabilities Example – Assume that a company has a total annual revenue of $500,000, expenses other than depreciation of $250,000, and a depreciation expense of $100,000 for tax accounting and $50,000 for financial reporting. The income for tax reporting purposes would be computed two ways, assuming a 34% tax rate: 2-27

Liabilities Taxes actually paid ($51,000) are less than the tax expense ($68,000) reported in the financial statements. To reconcile the $17,000 difference between the expense recorded and the cash outflow, there is a deferred tax liability of $17,000: 2-28

Stockholders’ Equity Also called shareholders’ equity Residual interest in assets that remains after deducting liabilities Owners bear greatest risk and benefit from greatest rewards. 2-29

Stockholders’ Equity Common Stock Shareholders do not ordinarily receive a fixed return have voting privileges in proportion to ownership interest can benefit through price appreciation can suffer through price depreciation 2-30

Stockholders’ Equity Common Stock Dividends are declared at the discretion of a company’s board of directors Amount listed on the balance sheet is based on the par or stated value of the shares issued (which bears no relationship to actual market price). 2-31

Stockholders’ Equity Retained Earnings Sum of every dollar a company has earned since 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 2-32

Stockholders’ Equity Retained Earnings Key link between the income statement and the balance sheet Unless there are unusual transactions affecting the retained earnings account, Beginning retained earnings Net income (loss) Ending retained earnings – Dividends = ± 2-33

Stockholders’ Equity Other Equity Accounts Preferred stock Accumulated other comprehensive income (expense) Treasury Stock Employee benefit trusts Equity attributable to non-controlling interests 2-34

Stockholders’ Equity 2-35

Quality of Financial Reporting Economic recession of 2008 and many market gyrations since can be traced directly to overvaluation of balance sheet assets. When financial reporting does not reflect economic reality quality and usefulness are significantly impaired. Type of debt used to finance assets, commitments and contingencies, and the classification of leases relate directly to quality of financial reporting. 2-36

Quality of Financial Reporting “Commitments and Contingencies” disclosure in the notes to financial statements provide important information about off-balance sheet financing and other complex financing arrangements. Enron is a prime example of a company with enormous activity reported in the “Commitments and Contingencies” disclosure. 2-37

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 find many of the same accounts listed under different titles. 2-38

Create a Balance Sheet Using material from Paul’s Guitar Store, work individually to create a balance sheet for year end Your balance sheet should include the following 1) Total Current Assets & 2) Total Long Term Assets 3) Total Assets 4) Total Current Liabilities & 5) Total Long Term Liabilities 6) Total Liabilities 7) Total Shareholders’ Equity 8) Total Liabilities & Shareholders’ Equity 2-39