4. General Knowledge

What is liquidity?

The ability of a company to convert its assets to cash to pay its current liabilities.

What is long-term solvency?

Refers to an assessment of whether a company will be able to pay all its liabilities, which includes long-term liabilities as well.

What is one important limitation of the balance sheet?

One important limitation is that a company's book value, it is reported as assets - liabilities as shown in the balance sheet, usually will not directly measure the company's market value.

What are the two primary reasons a company’s book value in the balance sheet does not equal its market value?

1. Many assets measured at historical cost.

2. Unrecognized assets - such as trained employees, loyal customer relationships are not recognized as assets on the balance sheet.

What are current assets?

Cash and other assets that can be reasonably expected to be converted to cash or consumed within one year from the balance sheet date, or within the normal operating cycle of the business if that's longer than one year.

How are current assets listed on the balance sheet?

In order of their liquidity.

What is the operating cycle for a company?

Refers to the period of time from the initial outlay of cash for the purchase of inventory until the time the company collects cash from a customer from the sale of inventory.

What are types of current assets that can be on the balance sheet?

1. Cash and equivalents

2. Short-term investments

3. Accounts receivable (net)

4. Inventories

5. Prepaid expenses and other current assets

6. Restricted cash (if used within one year)

What are cash equivalents?

Defined as short-term investments that have a maturity date no longer than three months from the date of purchase.

When is restricted cash classified as a current asset vs a long-term asset?

Restricted cash is classified as a current asset if it is expected to be used within one year from the balance sheet date. Otherwise, restricted cash is classified as a long-term asset.

How are accounts receivables typically reported on the balance sheet?

Typically reported at the net amount expected to be collected, which is total receivables - allowance for the estimate of uncollectible accounts.

What inventories are reported on the balance sheet for a manufacturing company?

Raw materials inventory, work in process inventory, finished goods inventory

How do we determine whether a prepaid expense is current or noncurrent?

If rent was prepaid for a year, then the prepayment is classified as a current asset. However, if rent were prepaid for a period extending beyond one year, that portion of the prepayment is classified as a long-term asset.

What are long-term assets?

Long-term assets include assets that are expected to be converted to cash or consumed in more than one year (or operating cycle, if longer).

What are some typical classification of long-term assets?

1. Investments

2. Property, plant, and equipment

3. Operating lease assets

4. Intangible assets

5. Other long-term assets (Goodwill, Deferred income taxes, long-term prepaid expenses, long-term restricted cash, long-term investments not reported under investments earlier)

What is property, plant, and equipment?

Assets that are tangible, long-lived, and used in the operations of the business. Can include natural resources such as mineral mines.

How are intangibles reported on the balance sheet?

Reported at their purchase price less accumulated amortization.

How are research and development costs recorded?

They are expensed as incurred.

What are some accounts that would go under current liabilities?

1. Current portion of long-term debt (within next year, or operating cycle if longer)

2. Notes payable

3. Accounts payable

4. Current portion of operating lease liabilities (within next year, or operating cycle if longer)

5. Deferred revenues

6. Accrued liabilities

7. Income taxes payable

What are some accounts that would go under long-term liabilities?

1. Long-term debt (long-term notes, bonds)

2. Operating lease liabilities

3. Pension obligations

4. Deferred income taxes and other liabilities

What is the formula for equity (shareholders’ equity)?

Total assets - total liabilities

What are accounts that are common under shareholders’ equity on the balance sheet?

1. Common stock (part of paid-in capital)

2. Additional paid-in capital (part of paid-in capital)

3. Retained earnings

4. Accumulated other comprehensive income.

What does retained earnings represent?

Represents the accumulated net income reported by a company since its inception minus all dividends distributed to shareholders. In other words, it's the accumulated lifetime profits a company has earned for its shareholders but has not yet distributed to those shareholders.

What might the retained earnings account be called if it has a negative balance?

Accumulated deficit account

What is working capital used for?

Used to assess a company’s ability to pay its current liabilities (debts that will mature soon) with current assets

What is the current ratio used for?

Used to assess a company’s ability to pay its current liabilities (debts that will mature soon) with current assets. However, it is a more reliable liquidity indicator. This is b/c it shows a proportional amount rather than a working capital flat amount.

What is the acid-test ratio or quick ratio used for?

Used to assess a company’s ability to pay its current liabilities (debts that will mature soon) with certain current assets. However, it is more specifically measures a company’s ability to pay all current liabilities if they were due immediately.

Is a higher or lower current ratio better?

A higher ratio is better.

When might an unqualified opinion be issued?

When an auditor confirms that the financial statements are presented fairly in conformity with GAAP. Unqualified also means “clean” opinion.

When might a qualified opinion be issued?

If the financial statements have a departure from GAAP.