Intermediate Accounting Chapter 3
Chapter 3: The Balance Sheet and Financial Disclosures
Balance Sheet Overview
Definition: The balance sheet reports a company’s financial position at a specific point in time.
Structure: It provides an organized list of assets, liabilities, and equity, grouped by common characteristics.
Balance Sheet Example: Assets Section
Company: NIKE, INC.
Date: May 31, 2017
Currency: ($ in millions)
Assets:
Current Assets:
Cash and equivalents: $3,808
Short-term investments: $2,371
Accounts receivable (net): $3,677
Inventories: $5,055
Prepaid expenses and other current assets: $1,150
Total Current Assets: $16,061
Property and equipment (net): $7,198
Identifiable intangible assets (net): $283
Goodwill: $139
Deferred income taxes and other assets: $2,787
Total Long-Term Assets: $7,198
Total Assets: $23,259
Balance Sheet Example: Liabilities and Shareholders’ Equity Sections
Liabilities and Shareholders’ Equity:
Current Liabilities:
Current portion of long-term debt: $6
Notes payable: $325
Accounts payable: $2,048
Accrued liabilities: $3,011
Income taxes payable: $84
Total Current Liabilities: $5,474
Long-term debt: $3,471
Deferred income taxes and other liabilities: $1,907
Total Long-Term Liabilities: $5,378
Total Liabilities: $10,852
Shareholders’ Equity:
Common stock: $3
Additional paid-in capital: $8,638
Retained earnings: $3,979
Accumulated other comprehensive loss: $(213)
Total Shareholders’ Equity: $12,407
Total Liabilities and Shareholders’ Equity: $23,259
Usefulness of the Balance Sheet
Classification of Assets: Assets are classified based on common characteristics which leads to useful insights such as:
Liquidity: The ability of a company to convert its assets into cash.
Long-term Solvency: The ability of a company to meet all liabilities, including long-term ones.
Financial Flexibility: The ability to adapt cash flows for unexpected opportunities.
Limitations of the Balance Sheet
Market Value vs. Book Value: The book value calculated (assets minus liabilities) does not necessarily represent market value due to:
Assets often being recorded at historical cost rather than current sellable amounts.
Important resources or asset-like items may not be recorded, resulting in zero book value.
Classification of Elements within a Balance Sheet
Accounting Equation: Assets = Liabilities + Shareholders’ Equity
Subclassification of Balance Sheet Elements:
Current Assets
Long-term Assets
Current Liabilities
Long-term Liabilities
Paid-in Capital
Retained Earnings
Concept Check: Balance Sheet Classification
Question: Which of the following is a subclassification of assets in the balance sheet?
Choices:
Cash and cash equivalents
Revenue
Current assets
Disposable assets
Correct Answer: Current assets (Option C) are the first subclassification of assets in the balance sheet.
Current Assets
Definition: Current assets are expected to be converted to cash or consumed within one year or the normal operating cycle of the business if longer.
Components of Current Assets
Listed in order of liquidity:
Cash and cash equivalents
Short-term investments
Accounts receivable
Inventory
Prepaid expenses
Example of Current Assets - Nike, Inc.
As of May 31, 2017 and May 31, 2016 (in millions):
Cash and cash equivalents: $3,808 (2017) vs. $3,138 (2016)
Short-term investments: $2,371 (2017) vs. $2,319 (2016)
Accounts receivable (net): $3,677 (2017) vs. $3,241 (2016)
Inventory: $5,055 (2017) vs. $4,838 (2016)
Prepaid expenses and other current assets: $1,150 (2017) vs. $1,489 (2016)
Total Current Assets: $16,061 (2017) vs. $15,025 (2016)
Cash and Cash Equivalents
Definition: Cash equivalents are short-term investments with a maturity of three months or less from the date of purchase.
Examples:
Cash on hand and in banks
Bank drafts
Cashier’s checks
Money orders
Commercial paper
Money market funds
U.S. treasury bills
Short-Term Investments
Definition: Investments in stock and debt securities that the company intends to sell within the next 12 months or operating cycle, whichever is longer.
Types:
Held to maturity
Trading securities
Securities available for sale
Accounts Receivable
Definition: Arise from the sale of goods or services on account, often referred to as trade receivables.
Types:
Nontrade receivables: Result from loans by the company to individuals or other entities
Notes receivable: A formal agreement specifying payment terms.
Inventory
Categories for Manufacturers:
Finished goods
Work in process
Raw materials
Example - Intel Corp. Inventory Disclosure as of December 30, 2017:
Raw materials: $1,098
Work in process: $3,893
Finished goods: $1,992
Total Inventory: $6,983
Prepaid Expenses
Definition: Arise when a company incurs a cost of purchasing an asset in one period but will not expense it until a future period.
Examples:
Prepaid rent
Prepaid insurance
Concept Check: Current Assets
Question: Define the criterion used to classify an asset as current.
Correct Answer: Current assets are those expected to be consumed or converted within one year or the operating cycle, whichever is longer.
Long-Term Assets
Definition: Assets expected to be converted to cash or consumed in more than one year (or operating cycle).
Classifications:
Investments
Property, Plant, and Equipment
Intangible Assets
Other Long-Term Assets
Long-Term Assets - Example (Nike, Inc.)
As of May 31, 2017 and May 31, 2016 (in millions):
Property, Plant, and Equipment (net): $3,989 (2017) vs. $3,520 (2016)
Identifiable Intangible Assets (net): $283 (2017) vs. $281 (2016)
Goodwill: $139 (2017) vs. $131 (2016)
Deferred income taxes and other assets: $2,787 (2017) vs. $2,422 (2016)
Total Long-term Assets: $7,198 (2017) vs. $6,354 (2016)
Investments
Definition: Assets not used directly in operations, including:
Investments in equity and debt securities of other corporations.
Land held for speculation.
Long-term receivables.
Cash set aside for special purposes.
Property, Plant, and Equipment
Definition: Tangible, long-lived assets used in business operations, reported at cost less accumulated depreciation.
Examples:
Land
Buildings
Equipment
Machinery
Vehicles
Natural resources
Intangible Assets
Definition: Exclusive rights and valuable resources that generate future revenues, reported net of accumulated amortization.
Examples:
Patents
Copyrights
Trademarks
Franchises
Goodwill
Other Long-Term Assets
Definition: A catch-all classification for long-term assets not reported elsewhere;
Includes:
Long-term prepaid expenses (deferred charges)
Long-term investments of immaterial amounts.
Concept Check: Long-Term Assets
Question 1: Which of the following is most likely to be reported as a long-term asset?
Correct Answer: Buildings (b).
Question 2: What represents tangible, long-lived assets in business operations?
Correct Answer: Property, plant, and equipment (c).
Liabilities
Definition: Liabilities represent obligations to other entities.
Liabilities – Example (Nike, Inc.)
As of May 31, 2017 and May 31, 2016 (in millions):
Current Liabilities:
Current portion of long-term debt: $6 (2017) vs. $44 (2016)
Notes payable: $325 (2017) vs. $1 (2016)
Accounts payable: $2,048 (2017) vs. $2,191 (2016)
Accrued liabilities: $3,011 (2017) vs. $3,037 (2016)
Income taxes payable: $84 (2017) vs. $85 (2016)
Total Current Liabilities: $5,474 (2017) vs. $5,358 (2016)
Long-term debt: $3,471 (2017) vs. $1,993 (2016)
Deferred income taxes and other liabilities: $1,907 (2017) vs. $1,770 (2016)
Total Liabilities: $10,852 (2017) vs. $9,121 (2016)
Current Liabilities
Definition: Obligations expected to be satisfied with current assets or creating other current liabilities within one year or the operating cycle, whichever is longer.
Examples:
Accounts payable
Notes payable (short-term borrowings)
Deferred revenues
Accrued liabilities
Current portion of long-term debt
Types of Current Liabilities
Accounts Payable: Obligations to suppliers for merchandise or services purchased on account. Payments are generally due in 30 to 60 days.
Notes Payable: Written promises to pay cash at some future date, usually requiring interest in addition to the original obligation.
Other Types of Current Liabilities
Deferred Revenues: Cash received for future goods/services; revenue is recognized when goods/services are provided (e.g., gift cards).
Accrued Liabilities: Obligations for expenses incurred but unpaid (e.g., salaries, interest).
Current Maturities of Long-Term Debt
Long-term notes, loans, and bonds payable that will become payable within the next year or in installments.
Example: A $1,000,000 note requiring $100,000 in principal payments annually over 10 years.
Long-Term Liabilities
Definition: Liabilities due to be settled more than one year (or operating cycle) after the balance sheet date.
Implications: Future cash flows and long-term solvency are assessed through reporting terms, interest rates, and details in disclosure notes.
Examples of Long-Term Liabilities
Long-term notes
Bonds
Pension obligations
Lease obligations
Distinction Between Current and Long-Term Liabilities
The key distinction lies in time until the obligation is expected to be satisfied:
Current liabilities: less than one year.
Long-term liabilities: more than one year or operating cycle, if longer.
Shareholders’ Equity
Definition: Shareholders' equity is calculated as assets minus liabilities: Assets - Liabilities = Shareholders’ Equity.
Components:
Primarily derived from:
Paid-in capital
Retained earnings
Might also include other components such as accumulated other comprehensive income (AOCI).
Shareholders' Equity - Example (Nike, Inc.)
As of May 31, 2017 and May 31, 2016 (in millions):
Common stock (shares outstanding): $3 (1,643 shares, 2017) vs. $3 (1,682 shares, 2016)
Additional paid-in capital: $8,638 (2017) vs. $7,786 (2016)
Retained earnings: $3,979 (2017) vs. $4,151 (2016)
Accumulated other comprehensive loss: $(213) (2017) vs. $318 (2016)
Total Stockholders' Equity: $12,407 (2017) vs. $12,258 (2016)
International Financial Reporting Standards: Balance Sheet
Differences from U.S. GAAP:
IFRS specifies minimum items to present.
GAAP lacks minimum requirements.
IAS No. 1 renamed balance sheet to statement of financial position.
IFRS often reports noncurrent items first, while GAAP presents current assets first.
Annual Report Disclosures
Requirement: Public companies must provide shareholders with an annual report including:
Financial statements (balance sheet, etc.)
Additional disclosures (business conditions, risk factors, etc.)
Disclosure Notes
Purpose: Explain data in financial statements or provide information not directly related to specific items.
Examples: Summary of significant accounting policies, subsequent events, related third-party transactions (e.g., pension plans, leases).
Specific Disclosure Notes
Summary of Significant Accounting Policies: Important company choices in accounting methods.
Subsequent Events: Events occurring after the fiscal year-end but before statements are issued (e.g., issuance of debt).
Noteworthy Events and Transactions: Transactions that significantly affect evaluations (e.g., related-party transactions, errors, fraud, illegal acts).
Management’s Discussion and Analysis & Responsibilities
Management's Discussion: Provides biased yet informed perspectives on significant trends and uncertainties about:
Operations
Liquidity
Capital resources
Management Responsibilities Section: Asserts management responsibility for information in the report and also addresses internal control procedures.
Compensation of Directors and Top Executives
SEC Requirements: Companies must disclose compensation for directors and top executives, typically in a proxy statement.
Auditors’ Report
Overview: Auditors examine financial statements and internal controls, providing an opinion on fairness.
Types of Auditors’ Reports:
Unqualified
Unqualified with an explanatory paragraph
Qualified
Adverse/disclaimer
Unqualified Auditors’ Reports
Definition: Given when financial statements conform to generally accepted accounting principles (GAAP).
Unqualified with an Explanatory Paragraph
Usage: When the auditor finds that important information needs emphasis alongside the unqualified opinion (e.g., lack of consistency).
Other Audit Reports
Circumstances for Issuing: Issues that lead to qualified, adverse, or disclaimer opinions (e.g., nonconformity with GAAP).
Using Financial Statement Information
Purpose: Information helps investors predict the company's future.
Concerned Areas:
Default risk
Operational risk
Financial Statement Analysis
Methods: Common methods for analysis include:
Comparative financial statements
Horizontal analysis
Vertical analysis
Ratio analysis
Liquidity Ratios
Definition: Indicates a company’s ability to convert assets to cash to meet current obligations.
Common Ratios:
Current Ratio:
Acid-Test Ratio:
Current Ratio Example (Nike)
Current ratio =
Acid-Test (Quick) Ratio Example (Nike)
Quick assets total: $9,856
Acid-test ratio =
Are These Liquidity Ratios Adequate?
Industry Standards: Assessment against industry averages or previous year’s ratios; Nike above industry average indicates good liquidity.
Solvency Ratios
Definition: Indicate a company’s ability to meet long-term debts.
Common Ratios: Include debt to equity ratio and times interest earned ratio.
Debt to Equity Ratio
Definition: Compares resources from creditors with those from owners; a higher ratio indicates higher risk.
Example (Nike):
Debt to equity ratio =
Times Interest Earned Ratio
Importance: Helps assess a company’s ability to pay interest charges.
Calculation:
Relationship between Risk and Profitability
Discussion about the potential of borrowed funds for higher returns, referred to as favorable financial leverage.
Favorable Financial Leverage Example
Scenario: Two alternatives analyzed for capitalizing a company’s revenue before interest and taxes, highlighting varying ROI depending on debt levels.
Reporting Segment Information
Purpose: Facilitates analysis of diversified companies.
Reportable Operating Segment: Determined through a management approach, needs revenue generation and expense incurrence capabilities.
Required Disclosures for Operating Segments
General info, reported profit/loss, segment assets, reconciliations.
Information About Major Customers
Needs disclosure of significant revenue reliance; if a single customer accounts for 10% or more revenue, details must be provided.
International Financial Reporting Standards: Segment Reporting
Differences from GAAP concerning segment reporting require additional liabilities disclosures under IFRS.