Understanding Financial Statements EIGHTH EDITION

Understanding Financial Statements EIGHTH EDITION • Lyn M. Fraser • Aileen Ormiston

The Balance Sheet Also called the statement of condition or statement of financial position Shows the financial condition or financial position of a company on a particular date Financial Condition (C) 2007 Prentice Hall, Inc.

Financial Condition (cont.) Assets = What the firm owns Liabilities = What the firm owes to outsiders Stockholders’ equity = What the firm owes to Internal owners Assets = Liabilities + Stockholders’ equity (C) 2007 Prentice Hall, Inc.

General Parameters • Consolidation – when financial statements are combined due to parent owning more than 50% of voting stock in subsidiary • Balance Sheet Date • prepared at a point in time/on a particular date at end of accounting period • end of accounting period date can be calendar year or fiscal year or interim period such as year, quarter, etc. (C) 2007 Prentice Hall, Inc.

General Parameters (cont.) • Comparative Data • SEC requires that Balance Sheet includes two years of data (current and prior year balances) • Provides reference point for determining changes in financial position over time (C) 2007 Prentice Hall, Inc.

General Parameters (cont.) • Common-Size balance sheet • useful tool for analyzing the balance sheet • expresses each item on the balance sheet as a percentage of total assets • form of vertical ratio analysis that allows comparison of firms regardless of size • useful for evaluating trends within a firm and to make industry comparisons (C) 2007 Prentice Hall, Inc.

Common-Size balance sheet (cont.)Comparison of two major retail companies* Comparison using $ ($ are in millions): Retailer ARetailer B Cash $ 5,488 $ 2,245 A/R 1,715 5,069 Inventories 29,447 5,384 Current Assets 38,491 13,922 PPE, net 65,408 16,860 Total Assets 120,223 32,293 *Data from SEC website, www.sec.gov (C) 2007 Prentice Hall, Inc.

Common-Size balance sheet(cont.)Comparison of two major retail companies* Comparison using common size balance sheet %: Retailer ARetailer B Cash 4.56 6.95 A/R 1.43 15.70 Inventories 24.49 16.67 Current Assets 32.02 43.11 PPE, net 54.41 52.21 *Data from SEC website, www.sec.gov (C) 2007 Prentice Hall, Inc.

Assets Generally presented in order of liquidity Common Balance Sheet Accounts/Groupings • Current Assets • Cash and Marketable Securities • Accounts Receivable • Inventories • Prepaid Expenses • Long-Term Assets • Property, Plant, and Equipment • Other Assets (C) 2007 Prentice Hall, Inc.

A Few Definitions Current Assets-Cash or other assets expected to be converted into cash within one year or one operating cycle, whichever is longer OperatingCycle-Time required to purchase or manufacture inventory, sell the product, and collect the cash (C) 2007 Prentice Hall, Inc.

Cash and Marketable Securities Two accounts are often combined as “Cash and Cash Equivalents” • Cash in any form—cash awaiting deposit or in a bank account • Generally includes currency, coin, balances in checking and other demand or “near demand” accounts Cash (C) 2007 Prentice Hall, Inc.

Cash and Marketable Securities (cont.) Marketable Securities • Also called “short-term investments” • Are cash substitutes • Represent cash not needed immediately in the business • Temporarily invested to earn a return • Have short-term maturities • May include T-bills, certificates, notes, bonds, CD’s and commercial paper (C) 2007 Prentice Hall, Inc.

Statement of Financial Accounting Standards No. 115 Effective for fiscal years beginning after December 15, 1993 Requires the separation of investment securities into three categories: 1. Held to maturity 2. Trading securities 3. Securities available for sale (C) 2007 Prentice Hall, Inc.

Statement of Financial Accounting Standards No. 115 (cont.) Applies to debt securities that the firm has the positive intent and ability to hold to maturity Reported at amortized cost Held to Maturity (C) 2007 Prentice Hall, Inc.

Statement of Financial Accounting Standards No. 115 (cont.) Debt and equity securities that are held for resale in the short term Reported at fair value with unrealized gains and losses included in earnings Trading Securities (C) 2007 Prentice Hall, Inc.

Statement of Financial Accounting Standards No. 115 (cont.) Securities Available for Sale Debt and equity securities that are not classified as one of the other two categories Reported at fair value with unrealized gains or losses included in comprehensive income (C) 2007 Prentice Hall, Inc.

Statement of Financial Accounting Standards No. 115 (cont.) Does not apply to investments in consolidated subsidiaries nor to investments in equity securities accounted for under the equity method (C) 2007 Prentice Hall, Inc.

Accounts Receivable Arise from sales transactions to customers on credit Reported on the balance sheet at NET REALIZABLE VALUE Net Realizable Value = Accounts Receivable - Allowance for Doubtful Accounts (C) 2007 Prentice Hall, Inc.

A Word on the “Allowance…” • Management must estimate the dollar amount of accounts receivable they expect to be uncollectible • Affects balance sheet valuation AND bad debt expense on income statement • Can be important in assessing earnings quality--changes should be analyzed (C) 2007 Prentice Hall, Inc.

Inventories (cont.) Retail Company One type of inventory: Finished goods Manufacturing Company Three types of inventories: • Raw materials • Work-in-process • Finished goods (C) 2007 Prentice Hall, Inc.

Inventories (cont.) Accounting method chosen to value inventory and the associated measurement of cost of goods sold have a considerable impact on a company’s financial position and operating results (C) 2007 Prentice Hall, Inc.

Inventory Accounting Methods Inventory valuation is based on an assumption regarding the flow of goods Has nothing to do with the actual order in which products are sold Cost flow assumption made in order to match the cost of products sold to the revenue generated (C) 2007 Prentice Hall, Inc.

Inventory Accounting Methods (cont.) Accounting Method FIFO LIFO Average Cost Cost of Goods Sold (Income Statement) first purchases last purchases (close to current cost) average of all purchases Inventory Valuation (Balance Sheet) last purchases (close to current cost) first purchases average of all purchases (C) 2007 Prentice Hall, Inc.

Inventory Accounting Methods (cont.) Produces the highest COGS expense and the lowest ending inventory valuation Matches current costs to current sales LIFO During Inflation (C) 2007 Prentice Hall, Inc.

Inventory Accounting Methods (cont.) Produces the lowest COGS expense and the highest ending inventory valuation Values ending inventory at current cost FIFO During Inflation (C) 2007 Prentice Hall, Inc.

Inventory Accounting Methods (cont.) Inventory valuation may significantly affect BOTH the balance sheet and the income statement Disclosure of inventory cost flow assumption found in notes Inventory reported on balance sheet at LOWER OF COST OR MARKET (C) 2007 Prentice Hall, Inc.

Prepaid Expenses Represent expenses paid in advance-- included in current assets if they expire within one year or one operating cycle Usually not a material item Present few or no reporting or valuation issues (C) 2007 Prentice Hall, Inc.

Property, Plant, and Equipment (PP&E) Encompasses a company’s fixed assets • Also called tangible, long-lived, and capital assets Fixed assets other than land are “depreciated” over the period of time they benefit the firm • process of depreciation is method of allocating the cost of long-lived assets (C) 2007 Prentice Hall, Inc.

Property, Plant, and Equipment (PP&E) (cont.) • Straight linespreads the expense evenly by periods • Accelerated yields higher depreciation expense in the early years of an asset’s useful life, and lower depreciation expense in the later years • Units of production bases depreciation expense for a given period on actual use Depreciation methods:    (C) 2007 Prentice Hall, Inc.

Property, Plant, and Equipment (PP&E) (cont.) Proportion of fixed assets (PP&E) in a company’s asset structure determined by nature of the business Comparisons between firms can be difficult due to different depreciation methods and estimates (C) 2007 Prentice Hall, Inc.

Other Assets Can include multitude of other noncurrent items such as: • Property held for sale • Start-up costs in connection with a new business • Cash surrender value of life insurance policies • Long-term advance payments • Long-term investments • Intangible assets (C) 2007 Prentice Hall, Inc.

Other Assets—Intangible Most important for analytical purposes because of potential materiality Arises when one company acquires another company for a price in excess of the fair market value of the net identifiable assets acquired Goodwill (C) 2007 Prentice Hall, Inc.

Goodwill (cont.) Beginning in 2002, companies required to evaluate goodwill and determine whether it has lost value Amount of impairment is expensed in the year the determination is made (C) 2007 Prentice Hall, Inc.

Goodwill (cont.) Some corporations take enormous write-offs when companies they have acquired lose value Earnings increase for some firms relative to prior years because amortization expense is no longer recorded (C) 2007 Prentice Hall, Inc.

Goodwill (cont.) Example of the impact the 2002 change for goodwill expense had on a major entertainment company over a 5 year period * ($ in millions) YearGW ImpairmentGW Amortization 2005 $ 24 $ ---- 2004 10 ---- 2003 318 ---- 2002 44,039 ---- 2001 ---- 6,366 *Data from SEC website, www.sec.gov (C) 2007 Prentice Hall, Inc.

Liabilities Represent claims against assets by creditors Current Liabilities must be satisfied in one year or one operating cycle and include: • Accounts Payable • Notes Payable • Current Portion of Long-Term Debt • Accrued Liabilities • Unearned Revenue • Deferred Taxes (C) 2007 Prentice Hall, Inc.

Liabilities (cont.) • Short-term obligations that arise from credit extended by suppliers for the purchase of goods and services • Account is eliminated when the bill is satisfied • Significant changes from period to period often result from changes in sales volume, economic conditions or credit policies available to firm from its suppliers Accounts Payable (C) 2007 Prentice Hall, Inc.

Liabilities (cont.) When a firm has bonds, mortgages, or other forms of long-term debt outstanding, the portion of the principal that will be repaid during the upcoming year is classified as a current liability Current Maturities of Long-Term Debt (C) 2007 Prentice Hall, Inc.

Liabilities (cont.) • Result from recognition of expenses before they are actually paid • Under accrual accounting, expenses are recognized when INCURRED and thus ACCRUED, not when paid in cash • In this case, cash flow succeeds expense recognition Accrued Liabilities (C) 2007 Prentice Hall, Inc.

Liabilities (cont.) Unearned Revenue or Deferred Credits • Result from prepayments received in advance for services or products • Under accrual accounting, revenue is recognized when EARNED, not when cash is received • In this case, cash flow precedes revenue recognition (C) 2007 Prentice Hall, Inc.

Liabilities (cont.) Result of temporary differences in the recognition of revenue and expense for taxable income relative to reported financial income Deferred Federal Income Taxes (C) 2007 Prentice Hall, Inc.

Deferred Federal Income Taxes (cont.) Objective is to take advantage of all available tax deferrals in order to reduce actual tax payments, while showing the highest possible amount of reported net income (C) 2007 Prentice Hall, Inc.

Deferred Federal Income Taxes (cont.) Temporary Differences/Timing Differences When the total amount of expense and revenue recognized will eventually be the same for tax and financial reporting purposes (C) 2007 Prentice Hall, Inc.

Understanding Financial Statements EIGHTH EDITION