Structure of the Balance Sheet and Statement of Cash Flows Revsine/Collins/Johnson: Chapter 4

Learning objectives How balance sheet accounts are measured and classified. How balance sheet information is used. Balance sheet terminology and format outside the U.S. How footnotes aid your understanding of the firm’s accounting policies, subsequent events, and related-party transactions. How successive balance sheet and the income statement can be used to identify cash inflows and outflows. How the cash flow statements can be used to explain changes in successive balance sheets.

Learning objectives Concluded The distinction between operating, investing, and financing sources and uses of cash. How changes in current asset and current liability accounts can be used to compute “cash flows from operations” from accrual earnings.

Elements of the balance sheet How the money is invested Where the money came from ASSETS LIABILITIES EQUITY = + Probable future economic benefits Obtained from past transactions or events Probable future sacrifices of economic benefits Arising from present obligations To transfer assets or provide services in the future As a result of past transactions or events The residual interest in net assets.

Balance sheet information Rates of return ROA and ROCE ASSETS Capital structure Debt vs. Equity Helps Liquidity Cash conversion LIABILITIES + EQUITY assess Solvency Ability to pay debt Flexibility Operating and financial Balance Sheet

Balance sheet measurement conventions Historical cost ASSETS Current cost (fair value) Measurement LIABILITIES + EQUITY methods Net realized value Discounted present value Balance Sheet

Balance sheet classification: Overview ASSETS LIABILITIES EQUITY = + Current assets Property, plant and equipment Investments Other assets Current liabilities Long-term debt Other liabilities Preferred and common stock Additional paid-in capital Retained earnings

Balance sheet classification: Current assets Current market value Amortized cost or current market value Net realizable value Lower of (historical) cost or current market value

Balance sheet classification: Other assets Historical cost minus accumulated depreciation except that fair market value is used when “impaired”

Balance sheet classification: Liabilities Amount due at maturity Historical cost Discounted present value Mezzanine section

Balance sheet classification: Stockholders’ equity Historical par value Historical cost Mixture of different measurement bases

Analytical insights: Understanding the business $676.7 $5,285.9 Which company is: Deere E-Trade Potomac Electric Power Wal-Mart

Balance sheet presentation: International differences U.S. Format: U.K. Format: Current Assets Fixed Assets + + Long-lived Assets Current Assets - = Current Liabilities - Current Liabilities Non-current Liabilities + Non-current Liabilities = + Stockholders’ Equity Capital Employed

Balance sheet differences: Cadbury Schweppes PLC Consolidated Holding company only

Balance sheet differences: Cadbury Schweppes PLC (continued)

Balance sheet differences: Cadbury Schweppes PLC (concluded) Common stock par Capital in excess of par Retained earnings

Financial statement footnotes Footnotes are an integral part of companies’ financial reports. These “notes” help users better understand and interpret the numbers presented in the body of the financial statements. Three important notes: Summary of significant accounting policies. Subsequent event disclosures. Related party transactions

Financial statement notes: Significant accounting policies

Financial statement notes: Subsequent events

Financial statement notes: Related party transactions Related parties

Statement of cash flows Explains why a firm’s cash position changed between successive balance sheet dates. Here’s a balance sheet equation: Cash + Non-cash assets = Liabilities + Stockholders’ equity Cash Non-cash assets Liabilities = + - Stockholder’s equity ΔCash Δ Stockholders’ equity = + At the same time, it explains why non-cash assets, liabilities, and stockholders’ equity have changed. Δ Non-cash assets Δ Liabilities -

Cash flow statement format Cash inflows and outflows from transactions and events that affect operating income Operating Activities Cash inflows and outflows from loaning money to others, investing in securities, or in assets (e.g., equipment) used to produce goods and services. Investing Activities Cash inflows and outflows from borrowing money, selling stock, and paying dividends Financing Activities Δ Cash

Cash flow statement: Wal-Mart example Adjustments to accrual earnings

Cash flow statement: Wal-Mart example

Cash flow versus accrual earnings: HRB Advertising Company Opened for business on April 1, when each partner contributed $3,500 cash. Transactions for the year: Profit (accrual earnings) for the year was $3,725 but the checking account was overdrawn by $11,200

Here’s what happened at HRB

Deriving cash flows from operations: Indirect approach

HRB’s cash flow statement: Indirect approach

Deriving cash flow information: HRB one year later Bank loan refinanced Stock issued

Deriving cash flow information: HRB’s accrual earnings and cash flows

Deriving cash flow information: Overview Income statement Beginning Balance sheet Ending Balance sheet Cash flow statement You can always derive any one financial statement from information available in the other three statements.

Deriving cash flow information: Cash collected from customers

Deriving cash flow information: Salaries paid

Deriving cash flow information: Rent paid

Deriving cash flow information: Utilities paid

Deriving cash flow information: Cash paid for supplies

Deriving cash flow information: Interest paid

Deriving cash flow information: Office equipment cash flows Balance Sheet Office Equipment $15,000 Purchase (cash basis) $1,500 $16,500 Income Statement Depreciation Expenses Accumulated Depreciation $2,250 $3,250 3,250 $5,500 accrual basis

Deriving cash flow information: Bank loan and note cash flows $10,000 $10,000 $0 Note Payable Refinancing $0 $10,000 $10,000

Deriving cash flow information: Common stock and retained earnings $10,500 Stock issued (cash basis) $6,000 $16,500 Retain Earnings $3,735 Net losses (accrual basis) $1,725 $2,000

Deriving cash flow information: Cash receipts and disbursements

Summary The balance sheet shows the assets owned by a company at a given point in time, and how those assets are financed (debt vs. equity). Be alert for differences in balance sheet measurement bases, account titles, and statement format. Financial statement footnotes provide important information. The cash flow statement shows the change in cash for a given period, broken down into operating, investing, and financing activities.

Summary concluded Changes in certain balance sheet accounts help explain why operating cash flows differ from accrual income. Conversely, the cash flow statement helps to explain changes in balance sheet accounts T-accounts are a useful analytical device for deriving cash flow and accrual income information from successive balance sheets