1. The balance sheet and financial disclosures
Chapter 3
The balance sheet and financial disclosures
Chapter 3: The Balance Sheet and Financial Disclosures

2. Reports a company’s financial position on a particular date.
The Balance Sheet
Reports a company’s financial position on a particular date.
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 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. It is a freeze frame or snapshot of financial position at the end of a particular day marking the end of an accounting period.
A limitation of the balance sheet is that assets minus liabilities, measured according to generally accepted accounting principles, is not likely to be representative of the market value of the entity. Many assets, like land and buildings, are measured at their historical costs rather than their market values. Relatedly, many company resources including its trained employees, its experienced management team, and its reputation are not recorded as assets at all.
However, despite these limitations, the balance sheet does have significant value. The balance sheet provides information useful for assessing future cash flows, liquidity, and long-term solvency.

3. The Balance Sheet Claims against resources (Liabilities)
Remaining claims accruing to owners (Owners’ Equity)
Resources (Assets)
The three primary elements of the balance sheet are assets, liabilities and owners’ equity. Let’s look at each of these elements in more detail.

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

5. Short-term Investments
Current Assets
Cash
Cash Equivalents
Short-term Investments
Receivables
Inventories
Prepaid Expenses
Current Assets
Will be converted to cash or consumed within one year or the operating cycle, whichever is longer.
Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills.
Part I
Current assets include cash and all other assets expected to become cash or consumed within one year or the operating cycle, whichever is longer. Current assets includes cash, cash equivalents, short-term investments, receivables, inventories, and prepaid expenses.
Part II
Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. Cash that is restricted for a special purpose and not available for current operations should not be classified as a current asset.

6. Operating Cycle of a Typical Manufacturing Company
Use cash to acquire raw materials 1
Convert raw materials to finished product 2
Deliver product to customer
The operating cycle for a typical manufacturing company refers to the period of time necessary to convert cash to raw materials, raw materials to a finished product, the finished product to receivables, and then finally receivables back to cash. 3
Collect cash from customer 4

7. Property, Plant, & Equipment
Noncurrent Assets
Investments
Property, Plant, & Equipment
Intangibles
Other Assets
Noncurrent Assets
Not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer.
Noncurrent assets include investments, property, plant and equipment, intangibles, and other long-term assets. Noncurrent assets are not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer.

8. Property, Plant, and Equipment
Noncurrent Assets
Investments
Not used in the operations of the business.
Include both debt and equity securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes.
Intangible Assets
Used in the operations of the business but have no physical substance.
Include patents, copyrights, and franchises.
Reported net of accumulated amortization.
Property, Plant, and Equipment
Are tangible, long-lived, and used in the operations of the business.
Include land, buildings, equipment, machinery, and furniture as well as natural resources such as mineral mines, timber tracts, and oil wells.
Reported at original cost less accumulated depreciation (or depletion for natural resources).
Other Assets
Include long-term prepaid expenses and any noncurrent assets not falling in one of the other classifications.
Part I
Investments are nonoperating assets not used directly in operations. This category includes both debt and equity securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes.
Part II
Tangible, long-lived assets used in the operations of the business are classified as property, plant, and equipment. This category includes land, buildings, equipment, machinery, and furniture as well as natural resources such as mineral mines, timber tracts, and oil wells. These items are reported at original cost less accumulated depreciation (or depletion for natural resources).
Part III
Intangible assets generally represent exclusive rights that a company can use to generate future revenues. This category includes patents, copyrights, and franchises. These items are reported net of accumulated amortization.
Part IV
Balance sheets often include a catch-all classification of noncurrent assets called other assets. This category includes long-term prepaid expenses and any noncurrent assets not falling in one of the other classifications.

9. 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.
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.

10. Current Maturities of Long-Term Debt
Current Liabilities
Accounts Payable
Notes Payable
Accrued Liabilities
Unearned Revenues
Current Maturities of Long-Term Debt
Current Liabilities
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 are 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 include accounts payable, notes payable, accrued liabilities, and current maturities of long-term debt.

11. Long-term Liabilities
Long-term Notes
Mortgages
Long-term Bonds
Pension Obligations
Lease Obligations
Long-Term Liabilities
Obligations that will not be satisfied within one year or operating cycle, whichever is longer.
Long-term liabilities are not expected to be satisfied through current assets or creation of current liabilities within one year or the operating cycle, whichever is longer. Long-term liabilities include long-term notes, mortgages, long-term bonds, pension obligations, and lease obligations.

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

13. Accumulated Other Comprehensive Income
Shareholders’ Equity
Capital
Stock
Retained Earnings
Shareholders’ equity is composed of paid-in capital and retained earnings and may include a few other equity components such as accumulated other comprehensive income. We will learn more about accumulated other comprehensive income in later chapters.
Accumulated Other Comprehensive Income

14. Summary of Significant Accounting Policies
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.
Part I
The full-disclosure principle requires that financial statements provide all material, relevant information concerning the reporting entity. Disclosure notes typically span several pages and either explain or elaborate upon the data presented in the financial statements themselves, or provide information not directly related to any specific item in the statements. Disclosure notes must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions.
The summary of significant accounting policies conveys valuable information about the company’s choices from among various alternative accounting methods. For example, management chooses whether to use accelerated or straight-line depreciation and whether to use first-in, first-out; last-in, first-out; or weighted average to measure inventories. Typically, this first disclosure note consists of a summary of significant accounting polices that discloses the choices the company makes.
Part II
A subsequent event is a significant development that takes place after the company’s fiscal year-end but before the financial statements are issued. Examples include the issuance of debt or equity securities, a business combination or the sale of a business, the sale of assets, an event that sheds light on the outcome of a loss contingency, or any other event having a material effect on operations.
Part III
Some transactions and events occur only occasionally, but when they do occur are potentially important to evaluating a company’s financial statements. In this category are related party transactions, errors and irregularities, and illegal acts.
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.

15. Management Discussion and Analysis
Provides a biased but informed perspective of a company’s operations, liquidity, and capital resources.
The management discussion and analysis (MDA) provides a biased but informed perspective of a company’s operations, liquidity, and capital resources. The MDA section of an annual report relates management’s biased perspective, however, it can offer an informed insight that might not be available elsewhere.

16. Management’s Responsibilities
Preparing the financial statements and other information in the annual report.
Maintaining and assessing the company’s internal control procedures.
Auditors examine financial statements and the internal control procedures designed to support the content of those statements. Their role is to attest to the fairness of the financial statements based on that examination. However, management prepares and is responsible for the financial statements and other information in the annual report. Annual reports include a management’s responsibility section that asserts the responsibility of management for the information contained in the annual report as well as an assessment of the company’s internal control procedures.

17. Must comply with specifications of the AICPA and the PCAOB.
Auditors’ Report
Expresses the auditors’ opinion as to the fairness of presentation of the financial statements in conformity with generally accepted accounting principles.
The auditors’ report is issued by the certified public accountants who audit the financial statements. The auditors’ report informs users of the audit findings and draws attention to problems that might exist in the financial statements. In the audit report, the auditors express an opinion as to the fairness of presentation of the financial statements in conformity with generally accepted accounting principles. Every audit report looks similar and must comply with specifications of the American Institute of Certified Public Accountants and the Public Companies Accounting Oversight Board.
Must comply with specifications of the AICPA and the PCAOB.

18. Auditors’ Opinions Unqualified Qualified Adverse Disclaimer
Issued when the financial statements present fairly the financial position, results of operations, and cash flows are 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.
Part I
There are four types of audit opinions. An unqualified opinion is issued when the financial statements present fairly the financial position, results of operations, and cash flows are in conformity with generally accepted accounting principles.
Part II
A qualified opinion is issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole. Examples of exceptions are nonconformity with generally accepted accounting principles, inadequate disclosures, and a limitation or restriction of the scope of the examination.
Part III
An adverse opinion is issued when the exceptions are so serious that a qualified opinion is not justified. Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report.
Part IV
A disclaimer opinion is issued when insufficient information has been gathered to express an opinion.
Disclaimer
Issued when insufficient information has been gathered to express an opinion.

19. 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. The proxy statement contains disclosures on compensation to directors and executives and the stock options granted and held. This disclosure can be very informative because in some cases, options have made executive compensation seem extremely high. We will discuss stock options in more depth in a later chapter.
A proxy statement is sent each year to all shareholders, usually in the same mailing with the annual report.

20. 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.
Part I
Investors, creditors, and others use information that companies provide in corporate financial reports to make decisions. Comparative financial statements allow financial statement users to compare year-to-year financial position, results of operations, and cash flows.
Part II
Some analysts enhance their comparison by using horizontal analysis. 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).
Part III
Similarly, vertical analysis involves expressing each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, but within the same year. For example, cash inventory, and other assets can be restated as a percentage of total assets; net income and each expense can be restated as a percentage of revenues.
Part IV
No accounting numbers are meaningful in and of themselves. Ratio analysis allows analysts to control for size differences over time and among firms.
Ratio Analysis
Allows analysts to control for size differences over time and among firms.

21. Measures a company’s ability to satisfy its short-term liabilities
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
Liquidity refers to the readiness of assets to be converted to cash. Liquidity ratios compare a company’s obligations that will shortly become due with the company’s cash and other current assets that, by definition, are expected to be used to pay for the obligations that will be due in the short term.
The current ratio is calculated as current assets divided by current liabilities and measures a company’s ability to satisfy its short-term liabilities. A current ratio of 2 indicates that the company has twice as many current assets available as current liabilities. A company could have difficulty paying its liabilities even with a current ratio significantly greater than 1.o. For example, a large portion of the current assets could include inventory. If the inventory is not able to be converted into cash for several months, obligations may come due that could not be paid out of current assets.
The acid-test ratio is calculated as quick assets divided by current liabilities. Quick assets are current assets excluding inventories and prepaid items. By eliminating current assets less readily convertible into cash, this ratio provides a more stringent indication of a company’s ability to pay its current liabilities.

22. Financing Ratios Total liabilities Debt to equity ratio=
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
Investors and creditors, particularly long-term creditors, are vitally interested in a company’s long-term solvency and stability. The debt to equity ratio is calculated as total liabilities divided by shareholders’ equity. This ratio indicates the extent of reliance on creditors, rather than owners, in providing resources. The higher this ratio, the greater the creditor claims on assets, so the higher the likelihood an individual creditor would not be paid in full if the company is unable to meet its obligations.
The times interest earned ratio is a way to gauge the ability of a company to satisfy its fixed debt obligations by comparing interest charges with the income available to pay those charges. This ratio is calculated as net income plus interest expense plus taxes divided by interest expense. The times interest earned ratio indicates the margin of safety provided to creditors.

23. Appendix 3: Reporting by Operating Segment
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.
Reportable Operating Segment Characteristics
Appendix 3: Reporting by Operating Segment
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.
The following characteristics define an operating segment. An operating segment is a component of an enterprise:
That engages in business activities from which it may earn revenues and incur expenses.
Whose 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.
For which discrete financial information is available.
Engages in business activities from which it may earn revenues and incur expenses.
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.

24. 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.
For areas determined to be reportable operating segments, the following disclosures are required:
General information about the operating segment.
Information about reported 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.
Reconciliations of the totals of segment revenues, reported profit or loss, assets, and other significant items.
Interim period information.

25. Reporting by Geographic Area Information About Major Customers
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.
Statement of Financial Accounting Standards Number one hundred thirty one requires an enterprise to report certain geographic information unless it is impracticable to do so. This information includes revenues from external customers attributed to the enterprise’s country of domicile and attributed to all foreign countries in total from which the enterprise derives revenues, and long-lived assets other than financial instruments, long-term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets located in the enterprise’s country of domicile and located in all foreign countries in total in which the enterprise holds assets.
Revenues from major customers must also be disclosed. If ten percent or more of the revenue of an enterprise is derived from transactions with a single customer, the enterprise must disclose that fact, the total amount of revenue from each such customer, and the identity of the operating segment or segments earning the revenue. This information provides insight concerning the extent to which a company’s prosperity depends on one or more major customers.

26. End of Chapter 3.
End of Chapter 3