1 The Balance Sheet and Income Statement: A Closer Look CHAPTER F10 © 2007 Pearson Custom Publishing

2 Describe how the balance sheet and income statement were developed as financial statements. Learning Objective 1: © 2007 Pearson Custom Publishing

3 History and Development of the Balance Sheet & Income Statement Accounting “systems” have been around for a very long time (even B.C.). However, financial statements are a more recent development. Accounting “systems” have been around for a very long time (even B.C.). However, financial statements are a more recent development. Balance sheets have been traced back into the early 1600s. Balance sheets were the primary, and often the only, financial statement prepared. Balance sheets have been traced back into the early 1600s. Balance sheets were the primary, and often the only, financial statement prepared. © 2007 Pearson Custom Publishing

4 In the late 1800s, crude income statements began to develop. In the late 1800s, crude income statements began to develop. The income statement was not considered to be very important due to the fact that banks concentrated on balance sheet information when making their lending decisions. The income statement was not considered to be very important due to the fact that banks concentrated on balance sheet information when making their lending decisions. History and Development of the Balance Sheet & Income Statement © 2007 Pearson Custom Publishing

5 As companies began to finance their operations through the sale of stock (instead of bank loans), the importance of reporting annual performance to stockholders began to grow. As companies began to finance their operations through the sale of stock (instead of bank loans), the importance of reporting annual performance to stockholders began to grow. History and Development of the Balance Sheet & Income Statement © 2007 Pearson Custom Publishing

6 Although it took a long time for the income statement to “catch up” with the balance sheet, they are now seen as very important complements to one another. Although it took a long time for the income statement to “catch up” with the balance sheet, they are now seen as very important complements to one another. They both provide useful, although different, information for economic decision makers. They both provide useful, although different, information for economic decision makers. History and Development of the Balance Sheet & Income Statement © 2007 Pearson Custom Publishing

7 Organization of the Balance Sheet Remember the basic balance sheet equation: Remember the basic balance sheet equation: Assets = Liabilities + Owners’ Equity Assets = Liabilities + Owners’ Equity Shown below is a very basic balance sheet that shows totals, but no details: Shown below is a very basic balance sheet that shows totals, but no details: © 2007 Pearson Custom Publishing

8 Explain the organization and purpose of the classified balance sheet. Learning Objective 2: © 2007 Pearson Custom Publishing

9 Now, the same balance sheet, with details. First, the asset section. Classified Balance Sheet © 2007 Pearson Custom Publishing

10 Here is the Second Half of the Classified Balance Sheet Classified Balance Sheet

11 Discussion Questions Which of the two balance sheet presentations for Eliason and Company do you think would be more useful in predicting the future and timing of the company’s cash flow? Provide three specific examples to support your position. Which of the two balance sheet presentations for Eliason and Company do you think would be more useful in predicting the future and timing of the company’s cash flow? Provide three specific examples to support your position. © 2007 Pearson Custom Publishing

12 The asset section of a classified balance sheet is divided into at least two major sections: The asset section of a classified balance sheet is divided into at least two major sections: Current assets include cash and those other assets that are expected to become cash within one year or the operating cycle, whichever is longer. Current assets include cash and those other assets that are expected to become cash within one year or the operating cycle, whichever is longer. Classified Balance Sheet © 2007 Pearson Custom Publishing

13 Long-term (or non-current) assets are those that are expected to become cash after one year or will be used for more than one year, or the operating cycle, whichever is longer. Long-term (or non-current) assets are those that are expected to become cash after one year or will be used for more than one year, or the operating cycle, whichever is longer. Occasionally, an asset needs to be reclassified, either moving from current to long term, or vice versa. Occasionally, an asset needs to be reclassified, either moving from current to long term, or vice versa. Classified Balance Sheet © 2007 Pearson Custom Publishing

14 Liquidity Assets are listed on the classified balance in a descending order of liquidity. Liquidity is defined as “nearness to cash.” Cash is the most liquid of all assets. Assets are listed on the classified balance in a descending order of liquidity. Liquidity is defined as “nearness to cash.” Cash is the most liquid of all assets. Accounts receivable is more liquid than factory equipment, because receivables are expected to be converted into cash in the very near future (i.e., 30 to 60 days). Accounts receivable is more liquid than factory equipment, because receivables are expected to be converted into cash in the very near future (i.e., 30 to 60 days). © 2007 Pearson Custom Publishing

15 Discussion Questions Can you give examples of current assets that you think will never be converted into cash? If so, why do you think they are classified as current assets? Can you give examples of current assets that you think will never be converted into cash? If so, why do you think they are classified as current assets? If a company has property, plant, and equipment classified as long-term assets, does this mean that the company cannot sell one of its buildings in the next year? Explain your reasoning. If a company has property, plant, and equipment classified as long-term assets, does this mean that the company cannot sell one of its buildings in the next year? Explain your reasoning. © 2007 Pearson Custom Publishing

16 Investments Most major corporations have significant investments in the securities (stocks and bonds) of other corporations. Most major corporations have significant investments in the securities (stocks and bonds) of other corporations. These investments could be either short term or long term in nature, depending upon the intentions of management. These investments could be either short term or long term in nature, depending upon the intentions of management. © 2007 Pearson Custom Publishing

17 Intangible Assets Intangibles are long-term assets that do not have “physical substance.” Examples include patents, trademarks, and copyrights. Intangibles are long-term assets that do not have “physical substance.” Examples include patents, trademarks, and copyrights. Intangibles with a defined economic life are amortized over their economic lives. Amortization is a cost allocation procedure very similar to the way we depreciate long-term tangible assets. Intangibles with a defined economic life are amortized over their economic lives. Amortization is a cost allocation procedure very similar to the way we depreciate long-term tangible assets. © 2007 Pearson Custom Publishing

18 Liabilities are also classified as either current or long term. Liabilities are also classified as either current or long term. Current liabilities are those debts that need to be paid within one year (or the operating cycle). Examples would be salaries payable or a 6-month note payable. Current liabilities are those debts that need to be paid within one year (or the operating cycle). Examples would be salaries payable or a 6-month note payable. Classification of Liabilities © 2007 Pearson Custom Publishing

19 Long-term liabilities are not due until after one year. Examples include bonds payable and long-term notes payable. Long-term liabilities are not due until after one year. Examples include bonds payable and long-term notes payable. Again, occasionally a liability needs to be reclassified, moving from current to long term or vice versa. Can you give an example of why this might happen? Again, occasionally a liability needs to be reclassified, moving from current to long term or vice versa. Can you give an example of why this might happen? Classification of Liabilities © 2007 Pearson Custom Publishing

20 Stockholders’ Equity A classified balance sheet has at least two sections for stockholders’ equity: A classified balance sheet has at least two sections for stockholders’ equity: Paid-in capital (also called contributed capital) is listed first. This represents the amount invested by the stockholders when the corporation first issued the shares of stock. This includes both common and preferred stock. Paid-in capital (also called contributed capital) is listed first. This represents the amount invested by the stockholders when the corporation first issued the shares of stock. This includes both common and preferred stock. © 2007 Pearson Custom Publishing

21 Stockholders’ Equity The second section is retained earnings. Retained earnings represents the sum of all profits since the inception of the company minus any dividends declared. The second section is retained earnings. Retained earnings represents the sum of all profits since the inception of the company minus any dividends declared. © 2007 Pearson Custom Publishing

22 Explain why recurring and nonrecurring items are presented separately on the income statement. Learning Objective 3: © 2007 Pearson Custom Publishing

23 Recall the basic income statement equation: Revenues - Expenses = Net Income Recall the basic income statement equation: Revenues - Expenses = Net Income Shown below is a very basic income statement that shows totals, but no details: Shown below is a very basic income statement that shows totals, but no details: Organization of the Income Statement © 2007 Pearson Custom Publishing

24 Expanded Income Statement Detailed Expense Categories Subtotals Nonrecurring Item

25 The expanded income statement results in a presentation of the regular, recurring items separate from irregular, nonrecurring items. The expanded income statement results in a presentation of the regular, recurring items separate from irregular, nonrecurring items. For the Eliason Company, the extraordinary item is an example of a nonrecurring item. We have to report it, because it did happen this year, but we want to send a signal telling the reader not to expect it to happen again. For the Eliason Company, the extraordinary item is an example of a nonrecurring item. We have to report it, because it did happen this year, but we want to send a signal telling the reader not to expect it to happen again. Recurring and Nonrecurring Items © 2007 Pearson Custom Publishing

26 Interpret the net of tax disclosure of extraordinary items and discontinued operations. Learning Objective 4: © 2007 Pearson Custom Publishing

27 For recurring items: income tax expense is shown as a separate line item. It is typically the last expense deducted prior to the calculation of income from continuing operations. For recurring items: income tax expense is shown as a separate line item. It is typically the last expense deducted prior to the calculation of income from continuing operations. For nonrecurring items: the income tax effect of the nonrecurring gain or loss is included in the calculation of the gain or loss. The gain or loss is shown net of tax. For nonrecurring items: the income tax effect of the nonrecurring gain or loss is included in the calculation of the gain or loss. The gain or loss is shown net of tax. Income Tax Disclosure © 2007 Pearson Custom Publishing

28 Assume that your company had a nonrecurring gain of $100,000. That gain would add to your income taxes for the year. Assume that your company had a nonrecurring gain of $100,000. That gain would add to your income taxes for the year. Assume that you pay 25% in income taxes. Assume that you pay 25% in income taxes. Your reported gain would be $75,000 net of tax: $100,000 minus (25% X $100,000) Your reported gain would be $75,000 net of tax: $100,000 minus (25% X $100,000) Net of Tax Examples © 2007 Pearson Custom Publishing

29 Similarly, if your company had a $100,000 loss, the loss would result in a reduction of your taxes. Similarly, if your company had a $100,000 loss, the loss would result in a reduction of your taxes. Reducing your taxes gives you a smaller net loss. Reducing your taxes gives you a smaller net loss. Again using a 25% tax rate, the loss would be $75,000 net of tax. Again using a 25% tax rate, the loss would be $75,000 net of tax. Net of Tax Examples © 2007 Pearson Custom Publishing

30 If a company disposes of a business component of the business, it would be accounted for as a discontinued operation. If a company disposes of a business component of the business, it would be accounted for as a discontinued operation. To be considered a business component it has to a portion of the entity for which assets, results of operations, and activities can be separately identified. To be considered a business component it has to a portion of the entity for which assets, results of operations, and activities can be separately identified. Discontinued Operations © 2007 Pearson Custom Publishing

31 Another type of nonrecurring item is known as an extraordinary item. To be classified as extraordinary, an item must meet both of the following criteria: Another type of nonrecurring item is known as an extraordinary item. To be classified as extraordinary, an item must meet both of the following criteria: 1) unusual in nature, and 1) unusual in nature, and 2) infrequent in occurrence. 2) infrequent in occurrence. What is extraordinary for one company might be considered ordinary for the next. What is extraordinary for one company might be considered ordinary for the next. Extraordinary Items © 2007 Pearson Custom Publishing

32 Discussion Questions The following examples do not qualify as extraordinary items. For each one, explain specifically what criterion/criteria have not been met. The following examples do not qualify as extraordinary items. For each one, explain specifically what criterion/criteria have not been met. a) A citrus grower’s Florida crop is damaged by frost… a) A citrus grower’s Florida crop is damaged by frost… b) A textile manufacturer with only one plant moves to another location. It has not relocated a plant in twenty years and has no plans to do so in the foreseeable future…. b) A textile manufacturer with only one plant moves to another location. It has not relocated a plant in twenty years and has no plans to do so in the foreseeable future…. © 2007 Pearson Custom Publishing

33 Comprehensive Income In 1998, the FASB began requiring firms to report comprehensive income in addition to the net income on the traditional income statement. In 1998, the FASB began requiring firms to report comprehensive income in addition to the net income on the traditional income statement. Comprehensive income measures all changes in equity from nonowner sources. Comprehensive income measures all changes in equity from nonowner sources. © 2007 Pearson Custom Publishing

34 Comprehensive Income Most firms are choosing to include the information about comprehensive income in the statement of stockholders’ equity. Most firms are choosing to include the information about comprehensive income in the statement of stockholders’ equity. Alternatively, they could choose to issue a Alternatively, they could choose to issue a statement of comprehensive income or a statement of comprehensive income or a combined statement of income and comprehensive income. combined statement of income and comprehensive income. © 2007 Pearson Custom Publishing

35 Calculate earnings per share and properly disclose it on the income statement. Learning Objective 5: © 2007 Pearson Custom Publishing

36 Earnings Per Share One of the most highly scrutinized figures on financial reports is the earnings per share (EPS). One of the most highly scrutinized figures on financial reports is the earnings per share (EPS). EPS shows the direct relationship between company earnings and the number of shares of common stock outstanding. EPS shows the direct relationship between company earnings and the number of shares of common stock outstanding. © 2007 Pearson Custom Publishing

37 Earnings Per Share Basic and diluted EPS are always shown at the bottom of the income statement so that analysts and investors can easily find the data. Basic and diluted EPS are always shown at the bottom of the income statement so that analysts and investors can easily find the data. © 2007 Pearson Custom Publishing

38 Basic Earnings Per Share The basic EPS calculation is: Net income - Preferred dividends______ Weighted average common shares outstanding The basic EPS calculation is: Net income - Preferred dividends______ Weighted average common shares outstanding Basic earnings per share reports actual data based on the shares outstanding on the balance sheet date. Basic earnings per share reports actual data based on the shares outstanding on the balance sheet date. © 2007 Pearson Custom Publishing

39 Diluted Earnings Per Share A second EPS, known as diluted earning per share, shows worse case scenario for stockholders and potential investors. A second EPS, known as diluted earning per share, shows worse case scenario for stockholders and potential investors. If a company has convertible securities that could be converted into additional shares of common stock, those securities are potentially dilutive. In other words, the current common stockholders might suffer a reduction in the EPS if conversion occurred. If a company has convertible securities that could be converted into additional shares of common stock, those securities are potentially dilutive. In other words, the current common stockholders might suffer a reduction in the EPS if conversion occurred. © 2007 Pearson Custom Publishing

40 Earnings Per Share Example Assume XYZ Corp. had 50,000 common shares outstanding on 1/1/07. They issued another 10,000 shares on 10/1/07. Assume XYZ Corp. had 50,000 common shares outstanding on 1/1/07. They issued another 10,000 shares on 10/1/07. Net income for 2007 totaled $166,000. Net income for 2007 totaled $166,000. XYZ has 10,000 shares of convertible preferred stock outstanding. The dividend rate is $4 per share, and each share can be converted into 2 shares of common stock. XYZ has 10,000 shares of convertible preferred stock outstanding. The dividend rate is $4 per share, and each share can be converted into 2 shares of common stock. © 2007 Pearson Custom Publishing

41 Earnings Per Share Example The first step is to calculate the weighted average number of common shares outstanding: The first step is to calculate the weighted average number of common shares outstanding: DateSharesTimeWeight 1/150,000 9/1237,500 10/160,000 3/1215,000 Weighted average shares52,500 DateSharesTimeWeight 1/150,000 9/1237,500 10/160,000 3/1215,000 Weighted average shares52,500 © 2007 Pearson Custom Publishing

42 Earnings Per Share Example The second step is to calculate basic EPS: The second step is to calculate basic EPS: $166,000 - (10,000 X $4) =$126,000 52,500 shares 52,500 $166,000 - (10,000 X $4) =$126,000 52,500 shares 52,500 Basic EPS = $2.40 Basic EPS = $2.40 © 2007 Pearson Custom Publishing

43 Earnings Per Share Example For diluted EPS, assume the 10,000 preferred shares are converted into 20,000 common shares at the beginning of the year: For diluted EPS, assume the 10,000 preferred shares are converted into 20,000 common shares at the beginning of the year: $166,000 - $0 dividends =$166,000 52, ,000 shares 72,500 $166,000 - $0 dividends =$166,000 52, ,000 shares 72,500 Diluted EPS = $2.29 Diluted EPS = $2.29 © 2007 Pearson Custom Publishing

44 Describe the additional information provided by comparative financial statements. Learning Objective 6: © 2007 Pearson Custom Publishing

45 Most companies issue comparative financial statements. These statements show the results for more than just the most recent year. Most companies issue comparative financial statements. These statements show the results for more than just the most recent year. The SEC requires registered firms to report The SEC requires registered firms to report balance sheets for at least two years, balance sheets for at least two years, income statements for at least three years, income statements for at least three years, statements of equity for at least three years. statements of equity for at least three years. Comparative Financial Statements © 2007 Pearson Custom Publishing

46 Comparative financial statements give the reader the opportunity to view its financial condition and results of operations for more than one year, to see the company in the perspective of its continuous history. Comparative financial statements give the reader the opportunity to view its financial condition and results of operations for more than one year, to see the company in the perspective of its continuous history. Comparative statements also give analysts data to perform several analytical tests we will examine in Chapter 12. Comparative statements also give analysts data to perform several analytical tests we will examine in Chapter 12. Comparative Financial Statements © 2007 Pearson Custom Publishing

47 End of Chapter 10