Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Balance Sheet and Financial Disclosures 3

3-2 Learning Objectives Describe the purpose of the balance sheet and understand its usefulness and limitations.

3-3 The Balance Sheet Limitations:  The balance sheet does not portray the market value of the entity as a going concern nor its liquidation value.  Resources such as employee skills and reputation are not recorded in the balance sheet. Limitations:  The balance sheet does not portray the market value of the entity as a going concern nor its liquidation value.  Resources such as employee skills and reputation are not recorded in the balance sheet. Usefulness:  The balance sheet describes many of the resources a company has available for generating future cash flows.  It provides liquidity information useful in assessing a company’s ability to pay its current obligations.  It provides long-term solvency information relating to the riskiness of a company with regard to the amount of liabilities in its capital structure. Usefulness:  The balance sheet describes many of the resources a company has available for generating future cash flows.  It provides liquidity information useful in assessing a company’s ability to pay its current obligations.  It provides long-term solvency information relating to the riskiness of a company with regard to the amount of liabilities in its capital structure. The purpose of the balance sheet is to report a company’s financial position on a particular date.

3-4 Resources (Assets) Claims against resources (Liabilities) Remaining claims accruing to owners (Owners’ Equity) Balance Sheet

3-5 Learning Objectives Distinguish between current and noncurrent assets and liabilities. Identify and describe the various balance sheet asset classifications.

3-6 Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

3-7Cash Cash Equivalents Short-term Investments ReceivablesInventoriesPrepaymentsCash Cash Equivalents Short-term Investments ReceivablesInventoriesPrepayments Current Assets Will be converted to cash or consumed within one year or the operating cycle, whichever is longer. Current Assets Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills.

3-8 Current Assets Will be converted to cash or consumed within one year or the operating cycle, whichever is longer. Cash that is restricted for a special purpose and not available for current operations should not be classified as a current asset. Cash Cash Equivalents Short-term Investments ReceivablesInventoriesPrepaymentsCash Cash Equivalents Short-term Investments ReceivablesInventoriesPrepayments Current Assets

3-9 Operating Cycle of a Typical Manufacturing Company Use cash to acquire raw materials Convert raw materials to finished product Deliver product to customer Collect cash from customer

3-10 Noncurrent Assets Investments and Funds Property, Plant, & Equipment IntangiblesOther Investments and Funds Property, Plant, & Equipment IntangiblesOther Not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer Noncurrent Assets

3-11 Noncurrent Assets Other Assets 1.Includes long-term prepaid expenses and any noncurrent assets not falling in one of the other classifications Investments and Funds 1.Not used in the operations of the business 2.Includes both debt and equity securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes Property, Plant and Equipment 1.Are tangible, long-lived, and used in the operations of the business 2.Includes land, buildings, equipment, machinery, and furniture as well as natural resources such as mineral mines, timber tracts, and oil wells 3.Reported at original cost less accumulated depreciation (or depletion for natural resources) Intangible Assets 1.Used in the operations of the business but have no physical substance 2.Includes patents, copyrights, and franchises 3.Reported net of accumulated amortization ©

3-12 Learning Objectives Identify and describe the two balance sheet liability classifications.

3-13 Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities as a result of past transactions or events.

3-14 Current Liabilities Accounts Payable Notes Payable Accrued Liabilities Current Maturities of Long-Term Debt Accounts Payable Notes Payable Accrued Liabilities Current Maturities of Long-Term Debt Obligations expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer Current Liabilities

3-15 Long-term Liabilities Notes Payable Mortgages Bonds Payable Pension Obligations Lease Obligations Notes Payable Mortgages Bonds Payable Pension Obligations Lease Obligations Obligations that will not be satisfied within one year or operating cycle, whichever is longer Long-Term Liabilities

3-16 Shareholders’ Equity is the residual interest in the assets of an entity that remains after deducting liabilities.

3-17 Shareholders’ Equity Capital Stock Capital Stock Retained Earnings Treasury Stock Deferred Compensation Accumulated Other Comprehensive Income

3-18 Learning Objectives Explain the purpose of financial statement disclosures.

3-19 Disclosure Notes Summary of Significant Accounting Policies Conveys valuable information about the company’s choices from among various alternative accounting methods. Subsequent Events A significant development that takes place after the company’s fiscal year-end but before the financial statements are issued. Noteworthy Events and Transactions Transactions or events that are potentially important to evaluating a company’s financial statements, e.g., related parties, errors and irregularities, and illegal acts.

3-20 Learning Objectives Explain the purpose of management’s discussion and analysis.

3-21 Management Discussion and Analysis Provides a biased but informed perspective of a company’s operations, liquidity, and capital resources.

3-22 Management’s Responsibilities  Preparing the financial statements and other information in the annual report.  Maintaining and assessing the company’s internal control procedures.

3-23 Learning Objectives Explain the purpose of an audit and describe the content of the audit report.

3-24 Auditors’ Report Expresses the auditors’ opinion as to the fairness of presentation of the financial statements in conformity with generally accepted accounting principles Must comply with specifications of the AICPA and the PCAOB

3-25 Auditors’ Opinions Unqualified Issued when the financial statements present fairly the financial position, results of operations, and cash flows in conformity with GAAP Qualified Issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole Adverse Issued when the exceptions are so serious that a qualified opinion is not justified Disclaimer Issued when insufficient information has been gathered to express an opinion

3-26 Compensation of Directors & Top Executives Proxy Statement Information  Summary compensation table  Table of options granted  Table of options holdings A proxy statement is sent each year to all shareholders, usually in the same mailing with the annual report.

3-27 Learning Objectives Describe the techniques used by financial analysts to transform financial information into forms more useful for analysis.

3-28 Using Financial Statement Information Comparative Financial Statements Allow financial statement users to compare year-to-year financial position, results of operations, and cash flows Horizontal Analysis Expresses each item in the financial statements as a percentage of that same item in the financial statements of another year (base amount) Vertical Analysis Involves expressing each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, within the same year. Ratio Analysis Allows analysts to control for size differences over time and among firms

3-29 Learning Objectives Identify and calculate the common liquidity and financing ratios used to assess risk.

3-30 Liquidity Ratios = Current ratio Current assets Current liabilities Measures a company’s ability to satisfy its short-term liabilities = Acid-test ratio Quick assets Current liabilities Provides a more stringent indication of a company’s ability to pay its current liabilities

3-31 Liquidity Ratios—Federal Express = 1.05 $4,970 $4,732 Current ratio =.86 $4,073 $4,732 Acid-test ratio

3-32 Financing Ratios = Debt to equity ratio Total liabilities Shareholders’ equity Indicates the extent of reliance on creditors, rather than owners, in providing resources = Times interest earned ratio Net income + Interest expense + Taxes Interest expense Indicates the margin of safety provided to creditors

3-33 Financing Ratios—Federal Express = 1.38 $11,098 $8,036 Debt to equity ratio Times interest earned ratio = $1,455 $136

3-34 Appendix 3 Reporting Segment Information

3-35 Reporting by Operating Segment Reportable Operating Segment Characteristics Engages in business activities from which it may earn revenues and incur expenses Many companies operate in several business segments as a strategy to achieve growth and to reduce operating risk through diversification. Segment reporting facilitates the financial statement analysis of diversified companies. Operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance Discrete financial information is available

3-36 What Amounts Are Reported By An Operating Segment General information about the operating segment Segment profit or loss, segment assets, and the basis of measurement Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items Interim period information

3-37 Segment Reporting Reporting by Geographic Area SFAS 131 requires an enterprise to report certain geographic information unless it is impracticable to do so. Information About Major Customers Revenues from customers generating 10% or more of the revenue of an enterprise must be disclosed.

3-38 End of Chapter 3