Learning Objectives. Chapter 5. Balance Sheet. Learning Objective 1, 2, 3. Liquidity. Chapter Overview. Balance Sheet and Statement of Cash Flows

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1 Chapter 5 Balance Sheet and Statement of Cash Flows Campbell, Coca-Cola, American Airlines, Borders Learning Objectives 1. Explain uses, limitations of a balance sheet 2. Identify major classifications of balance sheet 3. Prepare a classified balance sheet 4. Indicate purpose of statement of cash flows 5. Identify content of statement of cash flows 6. Prepare a statement of cash flows 7. Usefulness of statement of cash flows 8. Determine needed supplemental disclosure 9. Describe major disclosure techniques 1 2 Learning Objective 1, 2, 3 Uses, limitations of a balance sheet Major classifications of balance sheet Prepare a classified balance sheet Balance Sheet Claims against resources (Liabilities) Resources (Assets) Remaining claims accruing to owners (Owners Equity) As of a point in time, such as December 31, Chapter Overview Balance sheet and disclosures help investors and creditors understand Amount, timing, risk of future cash flows Capital structure Liquidity Long-term solvency Financial flexibility Liquidity Measure of a company s cash position Ability to obtain cash in normal course of business Sufficient cash, ability to convert other assets to cash, to meet current needs Amount of time expected to elapse until asset converted into cash or liability paid Proposed SFAC 5 1

2 Liquidity and Solvency Liquidity (short-term) Ability to convert current assets into cash Ability to pay current liabilities Solvency (short-term or long-term) Ability to pay all debts Illiquidity and Insolvency Illiquidity Can pay current liabilities, not convenient Not enough cash to pay current liabilities Can convert non-cash assets to cash (A/R, inventory, plant assets) or borrow Insolvency Cannot generate cash to pay liabilities 7 8 Bankruptcy Bankruptcy does not mean Net losses, falling sales Bankruptcy does mean Cannot pay bills and loans when due Options Negotiate with lenders (no court involved) Ask judge to grant bankruptcy protection Ratios Liquidity measured by Working capital Current ratio Quick ratio Solvency measured by Debt ratio Debt to equity ratio Times interest earned ratio 9 10 Financial Flexibility Ability to raise cash as needed Borrow money Issue stock Ability to alter timing, amount of cash flows to respond to unexpected needs, opportunities Proposed SFAC Financial Flexibility To increase flexibility Low debt as percentage of assets Sufficient cash to pay current liabilities Positive cash flow from operating activities Increasing net income

3 Limitations of Balance Sheet Includes estimates and judgments The balance sheet does not include Market value as a going concern Liquidation value Employee skills, customer loyalty Internally developed resources such as patents, trademarks, copyrights Limitations of Balance Sheet Assets minus liabilities, measured according to GAAP, will not equal market value of business Does not measure market value, helps us judge market value GAAP Definition: Assets Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events Asset Section Current assets Long-term investments Property, plant, and equipment Intangible assets Other assets Current Assets Will be converted to cash or consumed within one year or operating cycle, whichever is longer Converted into cash (A/R, Inventory) Consumed (Prepaid rent, Supplies) Operating Cycle (Manufacturing) Use cash to acquire raw materials Convert raw materials to finished product Deliver product to customer 17 Collect cash from customer 18 3

4 Raytheon Operating Cycle Boeing Operating Cycle NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1: Summary of Significant Accounting Policies Consolidation and Classification For classification of certain current assets and liabilities, we use the duration of the related contract or program as our operating cycle, which is generally longer than one year. Note 1 Summary of Significant Accounting Policies Operating cycle For classification of certain current assets and liabilities, we use the duration of the related contract or program as our operating cycle, which is generally longer than one year and could exceed 3 years Current Assets Turnover as part of daily operations Inventory sold Receivables collected Prepaid assets consumed Current Assets Cash Cash equivalents Short-term investments Receivables Inventories Prepayments Valuation of Current Assets Cash Equivalents Item Basis of Valuation Cash and cash equivalents Fair value Short-term investments Fair value (usually, some exceptions) Receivables Estimated amount collectible Inventories Lower of cost or market Prepaid expenses Cost Listed in order of liquidity (nearness to $) Short-term debt securities Life of 90 days or less when purchased Lowest risk of default Insignificant interest rate risk Examples Commercial paper Money market funds U.S. treasury bills

5 Not Cash Cash not available for current operations because of restriction for special purpose not classified as cash Classify as Investment May be short-term or long-term Example: Accumulating cash to pay bond due in five years, long-term investment Restrictions must be disclosed in notes 25 Short-term Investments Short-term investments Debt, equity securities of another company Ability and intent to sell within one year or operating cycle, whichever is longer Three categories Held-to-maturity: Debt securities Trading: Debt or equity, sell in near term Available-for-sale: Debt or equity, not classified as held-to-maturity or trading 26 Receivables Presentation of Net Receivable Accounts receivables Also called trade receivables Shown net of uncollectible accounts Non-trade receivables (Note receivable) Loans and advances to individuals, suppliers, customers Formal contract signed, interest charged 27 Current assets Cash $1,000 Accounts receivable $600 Less allowance for doubtful accounts Inventory 2,000 Total current assets $3,500 Current assets Cash $1,000 Accounts receivable, net allowance of $ Inventory 2,000 Total current assets $3, Inventory Retailer: Finished goods Manufacturer: Raw materials Work-in-process Finished goods Required disclosures Basis of valuation (LCM) Method of cost (FIFO or LIFO) See annual reports: Current assets and notes 29 Non-current Assets Not expected to be converted to cash or consumed within one year or operating cycle, whichever is longer Assets which cannot be classified as current 30 5

6 Types of Non-current Assets Investments and Funds Property, Plant, & Equipment Intangibles Other noncurrent assets Investments and Funds Not used in operations of business Debt, equity securities other corporations Assets held for speculation Non-current receivables Cash set aside for special purposes Long-term Investments Equity (debt) securities of other corp. Held for foreseeable future (not for sale) Gain influence over related company Supplier Distributor Customer See Coca-Cola Property, Plant and Equipment Tangible Long-lived Used in operations of business Reported at original cost less accumulated depreciation (depletion for natural resources) Property, Plant and Equipment Land Buildings Equipment Machinery Furniture Natural resources Mineral mines Timber tracts Oil wells 35 Legal right Patents Copyrights Intangible Assets Franchises Help generate future revenue No physical substance Listed net of accumulated amortization 36 6

7 Other Assets Long-term prepaid expenses Any non-current assets not falling in other classifications and not large enough to list separately See annual reports: Non-current assets and notes GAAP Definition: Liabilities 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 Current Liabilities Obligations expected to be satisfied through current assets or creation of other current liabilities within one year or operating cycle, whichever is longer Use current assets OR create other current liabilities Not Current Liability Classify debt as long-term liability if management has intent and ability to Case #1 Refinance short-term debt with long-term debt Case #2 Retire short-term debt using non-current assets or equity Current Liabilities Long-term debt reclassified as current when due within one year Current maturities of long-term debt Installments on long-term debt due within next year Current Liabilities Accounts Payable Due to suppliers, vendors in 30 days Notes Payable Signed loan agreement, pay interest Accrued Liabilities / Accrued Expenses Recorded expense and liability Rent payable, advertising payable

8 Current Liabilities Unearned Revenues Cash received from customer before service performed, goods delivered Current Maturities of Long-Term Debt Portion of long-term debt due with next year or operating cycle, whichever longer Long-term Liabilities Obligations that will not be satisfied within one year or operating cycle, whichever is longer Will not required use of current assets or creation of current liabilities See annual reports: Current liabilities and notes Long-term Liabilities Notes Payable Mortgages Bonds Payable Pension Obligations Lease Obligations Long-term Liabilities Include all line items After current liabilities Before stockholders equity See annual reports: Long-term liabilities and notes Shareholders Equity Residual interest in assets of entity that remains after deducting liabilities Net assets Sources of Equity Invested by shareholders Paid-in capital Earned by corporation and reinvested Retained earnings

9 Shareholders Equity Cash received when stock sold to public Common stock at par Additional paid-in capital Retained earnings Treasury stock Deferred compensation Accum. other comprehensive income Learning Objectives 4, 5, 6, 7 Purpose of statement of cash flows Content of statement of cash flows Prepare a statement of cash flows Usefulness of statement of cash flows See annual reports: Shareholders equity and notes Cash Flows Statement of Cash Flows Question Where did our cash come from and where did it go to? Calculation Beg. Cash + Operating + Investing + Financing End. Cash Required for each income statement period presented Helps investors and creditors assess Future net cash flows Liquidity Long-term solvency 52 Operating Cash Flow Both net income and cash flows from operating activities represent same transactions Income statement: Accrual basis Statement of cash flows: Cash basis Cash Flows Operating activities Result from revenues and expenses Investing activities Result from long-term assets Financing activities Result from stockholders equity Notes payable (short or long term) 53 9

10 Cash Flows Statement Of Cash Flows INFLOWS Operating Activities Investing Activities Financing Activities Operating activities Collections from customers + Cash paid related to expenses Investing activities Cash Cash received from sale of long-term assets + Cash paid to purchase long-term assets OUTFLOWS Operating Activities Investing Activities Financing Activities Financing activities Cash received from investors and lenders + Cash paid to investors and lenders Operating Cash Flows: Direct Method Operating activities: Direct method Cash collected from customers 50,000 Cash received from interest 10,000 Cash paid to suppliers and employees (20,000) Cash paid for interest (2,000) Cash paid for income taxes (8,000) Net operating cash flow 30,000 Operating Cash Flows: Indirect Method Operating activities: Indirect method Net income 40,000 Adjustments to reconcile net income to net cash provided by operating activities (10,000) Net operating cash flow 30,000 Operating activities: Direct method Cash collected from customers 50,000 Cash received from interest 10,000 Cash paid to suppliers and employees (20,000) Cash paid for interest (2,000) Cash paid for income taxes (8,000) Net operating cash flow 30,000 Investing Activities Investing activities (related to long-term assets) Cash received from sale of land 10,000 Cash paid to purchase equipment (50,000) Net investing cash flow (40,000) Operating activities: Indirect method Net income 40,000 Adjustments to reconcile net income to net cash provided by operating activities (10,000) Net operating cash flow 30,000 10

11 Financing Activities Financing activities (related to SE and note payable) Cash received from sale of stock 60,000 Cash received from issuing notes 20,000 Cash dividends paid (10,000) Cash paid on principal of notes payable (80,000) Net financing cash flow (10,000) Direct operating cash flows Dollar Corporation Statement of Cash Flows For the year ended December 31, 2011 Operating activities (related to revenues, expenses) Cash collected from customers 50,000 Cash received from interest 10,000 Cash paid to suppliers and employees (20,000) Cash paid for interest (2,000) Cash paid for income taxes (8,000) Net operating cash flow 30,000 Investing activities (related to long-term assets) Cash received from sale of land 10,000 Cash paid to purchase equipment (50,000) Net investing cash flow (40,000) Financing activities (related to SE and note payable) Cash received from sale of stock 60,000 Cash received from issuing notes payable 20,000 Cash dividends paid (10,000) Cash paid on principle of notes payable (80,000) Net financing cash flow (10,000) Net change in cash (20,000) Beginning cash balance 25,000 Ending cash balance 5,000 Indirect operating cash flows Dollar Corporation Statement of Cash Flows For the year ended December 31, 2011 Operating activities (related to revenues, expenses) Net income 40,000 Adjustments to reconcile net income to net cash provided by operating activities (10,000) Net operating cash flow 30,000 Investing activities (related to long-term assets) Cash received from sale of land 10,000 Cash paid to purchase equipment (50,000) Net investing cash flow (40,000) Financing activities (related to SE and note payable) Cash received from sale of stock 60,000 Cash received from issuing notes payable 20,000 Cash dividends paid (10,000) Cash paid on principle of notes payable (80,000) Net financing cash flow (10,000) Net change in cash (20,000) Beginning cash balance 25,000 Ending cash balance 5,000 Assets Dollar Corporation Balance Sheet December 31, 2011 Liabilities Cash $ 5,000 Accounts payable $ 10,000 Accounts Receivable 8,000 Salary payable 5,000 Supplies 2,000 Note payable 15,000 Land 40,000 Total Liabilities 30,000 Building Financing activities (related 30,000 to SE Stockholders and note payable) Equity Equipment Cash received from sale 25,000 of stock Common Stock 60,000 Cash received from issuing notes Retained payable earnings 20,000 20,000 60,000 Cash dividends paid Total Equity (10,000) 80,000 Total Assets Cash paid on principle $ 110,000 of notes payable Total Liability, Equity (80,000) $ 110,000 Net financing cash flow (10,000) Net change in cash (20,000) Beginning cash balance 25,000 Ending cash balance 5,000 December 31, 2010 (a point in time) For Year Ended December 31, 2012 (a period of time) Statement of Cash Flows Increases Decreases December 31, 2011 (a point in time) Operating Activities: Direct and Indirect Methods Two Formats for Reporting Operating Activities Balance Sheet Cash 25,000 R/E 30,000 Income Statement Increases Decreases Statement of Retained Earnings Increases Decreases Balance Sheet Cash 5,000 R/E 60,000 Direct Method Sorts operating cash flow into categories Indirect Method Starts with accrual net income and converts to cash basis 66 11

12 Direct method Operating Activities Indirect method Operating Cash Flows Cash received from customers 509 Interest and dividends received 16 Cash paid to suppliers, employ. (381) Interest paid (11) Income taxes paid (31) Net income 71 Depreciation expense 17 Gain on sale of investments (2) Loss on sale of equipment 5 Decrease in accounts receivable 9 Decrease in interest receivable 2 Increase in inventory (10) Decrease in prepaid expenses 4 Increase in accounts payable 15 Decrease in accrued liabilities (6) Use information from Income statement Changes in current assets and current liabilities from comparative balance sheet Increase in interest payable 1 Decrease in income tax payable (4) Total 102 Total Radial Corporation Comparative Balance Sheet December 31, Cash 19 3 Accounts receivable Operating Interest receivable 6 8 activities Inventory Prepaid expenses 2 6 Total current assets Long-term investments 15 7 Investing Long-term notes receivable Radial Corporation Comparative Balance Sheet December 31, Cash 19 3 Short-term investments Operating Accounts receivable 6 8 activities Inventory Prepaid expenses 2 6 Total current assets Long-term investments 15 7 Investing Long-term notes receivable activities Equipment activities Equipment Accumulated deprecation Accumulated deprecation Total assets Total assets Accounts payable Accounts payable Operating Accrued liabilities 6 12 Operating Short-term notes payable 6 12 activities Interest payable 2 1 activities Interest payable 2 1 Income taxes payable 6 10 Income taxes payable 6 10 Total current liabilities Total current liabilities Financing Long-term notes payable Financing Long-term notes payable activities Common stock Retained earnings activities Common stock Retained earnings Total liabilities, equity Total liabilities,equity CONVERT ACCRUAL TO CASH ANALYZING ACCOUNTS Revenues Expenses Net Income Adjust Revenues to Cash Receipts Adjust Expenses to Cash Payments Cash Flows from Operating Activities Beginning accounts receivable $80 Ending accounts receivable $93 Increase $13 Sales $284 Calculate cash received from customers Accrual-Basis Accounting Cash-Basis Accounting

13 RECONCILING ACCOUNTS CUSTOMER COLLECTIONS Accounts Receivable Revenue, expense from income statement Adjust for change in related balance sheet accounts Cash flow from Operating Activity Beginning balance + Sales Collections = Ending balance $80 + $284 X X = = $ 93 $271 Sales revenue Change in Accounts receivable Cash collections from customers CUSTOMER COLLECTIONS JOURNAL ENTRY METHOD Accounts Receivable Beginning bal. 80 Sales Collections Ending bal. 93 Beginning accounts receivable $80 Ending accounts receivable $93 Increase $13 Sales $284 Date Description Debit Credit Accounts receivable 13 Cash Sales 284 increase A/R 13 = Cash flow JOURNAL ENTRY METHOD Beginning accounts receivable $80 Ending accounts receivable $93 Increase $13 Sales $284 Date Description Debit Credit Accounts receivable 13 Cash 271 Sales Radial Corporation Income Statement For the year ended December 31, 2009 Sales 500 Cost of goods sold 300 Selling expenses 57 General and administrative expenses 27 Depreciation expense 17 Interest revenue 14 Interest expense 12 Gain on sale of long-term investments 2 Loss on sale of equipment 5 Income tax expense 27 Net income 71 Assume all amounts on income statement are in cash 78 13

14 Cash 19 3 Accounts receivable (9) Interest receivable 6 8 (2) Operating Activities: Indirect Inventory Prepaid expenses 2 6 (4) Total current assets Start with net income Long-term investments 15 7 Long-term notes receivable Adjustments required Equipment Accumulated deprecation Reverse non-cash revenues and expenses Total assets Accounts payable Accrued liabilities 6 12 (6) Interest payable Income taxes payable 6 10 (4) Adjust for changes in current assets and current liabilities Ending balance is operating cash flow Total current liabilities Long-term notes payable Common stock Retained earnings Total liabilities and equity Cash Flows from Operating Activities (Indirect) Radial Corporation Income Statement Net income Adjustments for noncash effects + Depreciation expense + Loss on sale of assets Gain on sale of assets For changes in current assets and current liabilities For the year ended December 31, 2009 Sales 500 Cost of goods sold 300 Selling expenses 57 General and administrative expenses 27 Depreciation expense 17 Interest revenue 14 Interest expense 12 Increase in a current asset + Decrease in a current asset + Increase in a current liability Decrease in a current liability = Net cash flows from operating activities 81 Gain on sale of long-term investments 2 Loss on sale of equipment 5 Income tax expense 27 Net income 71 Reverse line items not included in operating activities Operating Activities Direct method Indirect method Cash received from customers 509 Net income 71 Interest and dividends received 16 Depreciation expense 17 Cash paid to suppliers, employ. (381) Gain on sale of investments (2) Interest paid (11) Loss on sale of equipment 5 Income taxes paid (31) Decrease in accounts receivable 9 Decrease in interest receivable 2 Increase in inventory (10) Decrease in prepaid expenses 4 Increase in accounts payable 15 Noncash Investing and Financing Activities Report significant investing, financing transactions not involving cash Exchange common stock for assets Conversion of bonds into common stock Issuance of debt to purchase assets Exchanges on long-lived assets Decrease in accrued liabilities (6) Increase in interest payable 1 Decrease in income tax payable (4) Total 102 Total 102 See Coca-Cola, Campbell Soup Annual Reports

15 Importance: Stmt of Cash Flow Cash flow from operating activity Most important number; should be positive Use to purchase assets, pay debts and div Cash flow from investing activity Is company growing or liquidating? Cash flow from financing activity Sources of financing: debt, equity Repayment of principle; dividends Free Cash Flow Cash flow available for purchasing investments, retiring debt, purchasing treasury stock, or increasing liquidity 85 Exercise 14 Problem 7 WileyPLUS Learning Objectives 8, 9 Supplemental disclosure required Describe major disclosure techniques 88 Disclosure Notes Summary of accounting policies Details of amounts on financial stmts Subsequent events Noteworthy events Contingencies Contractual situations Fair values Accounting Policies Describe significant policies Choice from among approved methods See annual reports: Notes and disclosure

16 Accounting Policies Accounting principles when alternates exist Principles peculiar to particular industry Unusual or innovative applications of accounting principles Subsequent Events A significant development occurs after the company s fiscal year-end but before financial statements issued Costco: Subsequent Event Cheesecake Factory: Subsequent Event Subsequent to year-end the Company experienced some business interruption in its Florida locations due to hurricane damage. With the exception of one warehouse, which has been closed since September 25, 2007 and is expected to reopen by November 22, 2007, all other warehouses incurred only minor damage and minimal disruption to their operations. Overall, the Company expects to incur losses in the range of $5 million to $7 million net of insurance recoveries Subsequent Event In January 2011, we announced our initial expansion plans outside of the United States. We entered into an exclusive licensing agreement with a Kuwaitbased company to build and operate The Cheesecake Factory restaurants in the Middle East. The agreement provides for the development of 22 restaurants over the next five years in the United Arab Emirates, Kuwait, Bahrain, Qatar and the Kingdom of Saudi Arabia. We do not expect this agreement to have a meaningful impact on our financial results in the near term. 94 Noteworthy Events GAP Inc.: Related Parties Transactions or events that are potentially important to evaluating a company s financial statements Contingencies (future outcome uncertain) Contractual situations (pensions, leases) Related parties transactions Errors and irregularities Illegal acts 95 We generally use a competitive bidding process for construction of new stores, expansions, relocations and major remodels (major store projects). In addition, we utilize a construction industry standard stipulated sum, non-exclusive agreement with our general contractors. As of January 31, 2004, we had 41 general contractors qualified to competitively bid in North America. Fisher Development, Inc. (FDI), a company that is wholly owned by the brother of Donald G. Fisher and the brother s immediate family, is one of our qualified general contractors

17 Techniques of Disclosure End of Chapter Parenthetical Explanations Notes Cross-Reference and Contra Items Supporting Schedules Terminology See annual reports: Notes and disclosure 97 17