Balance Sheet Notes

Chapter Roadmap

• Learning Objectives
  • LO 4.1: Explain the uses, limitations, and content of the balance sheet.
  • LO 4.2: Explain the purpose, content, preparation, and usefulness of the statement of cash flows.
• Topics
  • 4.1 Balance Sheet
    • Usefulness of the balance sheet
    • Limitations of the balance sheet
    • Classification in the balance sheet
    • Format of the balance sheet
  • 4.2 Statement of Cash Flows
    • Purpose of the statement of cash flows
    • Content of the statement of cash flows
    • Preparation of the statement of cash flows
    • Usefulness of the statement of cash flows
• Review and Practice section at the end of the chapter includes:
  • Targeted summary review
  • Multiple-choice questions with annotated solutions
  • Additional exercises and practice problems with solutions available in Wiley Course Resources.

4.1 Balance Sheet

• Learning Objective 1: Explain the uses, limitations, and content of the balance sheet.
• The balance sheet, also known as the statement of financial position, reports a business's assets, liabilities, and stockholders’ equity at a specific date.
• Usefulness of the Balance Sheet
  • Provides information about the nature and amounts of investments in enterprise resources, obligations to creditors, and the owners’ equity in net resources.
  • Helps in predicting the amounts, timing, and uncertainty of future cash flows.
  • Provides a basis for computing rates of return and evaluating the capital structure of the company.
  • Used to assess a company’s risk and future cash flows by analyzing liquidity, solvency, and financial flexibility.

ILLUSTRATION 4.1 Assessing a Company’s Liquidity, Solvency, and Financial Flexibility

Limitations of the Balance Sheet

• Major limitations:
  1. Historical Cost: Most assets and liabilities are reported at historical cost, which may not reflect their current fair value.
     • Example: Amazon reports land and buildings at $31.7$ billion, which may have appreciated since purchase, but the increase is only reported upon sale.
  2. Judgments and Estimates: Companies use judgments and estimates to determine many items.
     • Example: Dell estimates $94$ million of accounts receivable will be uncollectible, depreciates computer equipment over $3–5$ years, and estimates a warranty obligation of $341$ million.
  3. Omission of Valuable Items: The balance sheet omits many items of financial value that cannot be objectively recorded.
     • Example: The knowledge and skill of Intel employees are significant assets but are not recognized on the balance sheet because their value cannot be reliably measured.
     • Similarly, many liabilities are reported in an “off-balance-sheet” manner; Apple disclosed $8.2$ million of off-balance-sheet, noncancelable purchase obligations in the notes to its financial statements.

Accounting Matters: Stuck in Port

• A company’s balance sheet strength can significantly impact its ability to navigate a crisis.
• During the Covid-19 pandemic, the cruise industry effectively shut down.
  • Carnival Corporation: Burning through upward of $650$ million per month but had $7.6$ billion in liquidity due to a strong financial position.
    • CEO Arnold Donald: “Additional cash conservation efforts, combined with future liquidity measures, will enable us to sustain ourselves beyond 12 months into late [2021], even in a zero-revenue scenario.”
  • Royal Caribbean: The strength of its balance sheet, assets, and brands allowed it to raise upward of $6.5$ billion in new liquidity since the start of the pandemic.
• A strong balance sheet and financial flexibility were critical to survival.

Classification in the Balance Sheet

• Balance sheet accounts are classified into groups of similar items to arrive at significant subtotals.
• The arrangement shows important relationships.
• The FASB discourages the reporting of summary accounts alone (e.g., total assets, net assets, and total liabilities).
• Companies should report and classify individual items in sufficient detail to permit users to assess the amounts, timing, and uncertainty of future cash flows.
  • Example: Classifying accounts payable as a current liability indicates that the company must liquidate that payable in the next year or accounting cycle.
• Such classifications make it easier for users to evaluate the company’s liquidity, solvency, financial flexibility, profitability, and risk.
• To classify items, companies group items with similar characteristics and separate items with different characteristics.
  1. Assets that differ in their type or expected function in the company’s central operations or other activities.
     • Merchandise inventories should be reported separately from property, plant, and equipment.
  2. Assets and liabilities with different implications for the company’s financial flexibility.
     • Assets used in operations, like manufacturing equipment, should be reported separately from assets held for investment and assets subject to restrictions, such as leased equipment.
  3. Assets and liabilities with different general liquidity characteristics.
     • Cash should be reported separately from inventories.
• Elements of the Balance Sheet
  1. Assets: Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
  2. Liabilities: Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
  3. Equity: Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.
• Companies further divide these items into subclassifications.

ILLUSTRATION 4.2 Balance Sheet Classifications

• Assets
  • Current assets
  • Long-term investments
  • Property, plant, and equipment
  • Right-of-use assets
  • Intangible assets
  • Other assets
• Liabilities and Owners’ Equity
  • Current liabilities
  • Long-term debt
  • Owners’ (stockholders’) equity
• A company may classify the balance sheet in some other manner, but in practice, you usually see little departure from these major subdivisions.
• A proprietorship or partnership presents the classifications within the owners’ equity section a little differently.
• Current Assets
  • Current assets are cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer.
  • The operating cycle is the average time between when a company acquires materials and supplies and when it receives cash for sales of the product (for which it acquired the materials and supplies).
    • The cycle operates from cash through inventory, production, receivables, and back to cash.

ILLUSTRATION 4.3 Operating Cycles

• When several operating cycles occur within one year (generally for service and merchandising companies), a company uses the one-year period.
• If the operating cycle is more than one year, a company uses the longer period.
• Though not common, the tobacco, distillery, lumber, and shipbuilding industries have operating cycles longer than one year.
• Current assets are presented in the balance sheet in order of liquidity.

ILLUSTRATION 4.4 Current Assets and Basis of Valuation

• Item
  • Cash and cash equivalents
  • Short-term investments
  • Receivables
  • Inventories
  • Prepaid expenses
• Basis of Valuation
  • Fair value
  • Generally, fair value
  • Estimated amount collectible
  • Lower-of-cost-or-net realizable value/market
  • Cost
• A company does not report these five items as current assets if it does not expect to realize them in one year or in the operating cycle, whichever is longer.
• A company excludes from the current assets section cash restricted for purposes other than payment of current obligations or for use in current operations.
• Generally, if a company expects to convert an asset into cash or to use it to pay a current liability within a year or the operating cycle, whichever is longer, it classifies the asset as current.
• Cash
  • Most companies use the caption “Cash and cash equivalents” on their balance sheet.
  • Includes:
    • Cash: currency and demand deposits at a financial institution (e.g., checking, savings, and money market accounts).
    • Cash equivalents: short-term, highly liquid investments that will mature within three months or less (e.g., a certificate of deposit (CD)).
  • Reported at approximate fair value.
• A company must disclose any restrictions or commitments related to the availability of cash.
• If a company restricts cash for purposes other than current obligations, it excludes the cash from current assets.

ILLUSTRATION 4.5 Balance Sheet Presentation of Current and Noncurrent Restricted Cash

• The Walt Disney Company (in millions)
  • Current assets
    • Cash and cash equivalents: $5,418$
    • Other current assets: $979$
  • Other assets: $4,715$
• Note 2 (in part): Cash and cash equivalents consist of cash on hand and marketable securities with original maturities of three months or less. Cash and cash equivalents subject to contractual restrictions and not readily available are classified as restricted cash. The Company’s restricted cash balances are primarily made up of cash held as collateral for certain derivative instruments.
  • Cash and cash equivalents: $5,418$
  • Restricted cash included in:
    • Other current assets: $26$
    • Other assets: $11$
  • Total cash, cash equivalents, and restricted cash in the statement of cash flows: $5,455$
• Short-Term Investments
  • If a company has excess cash on hand, it may choose to invest that cash in stocks or bonds of other companies. The investments may be held for a short period of time or for many years.
  1. Equity securities: investments in preferred and common stock of other companies.
     • A company can buy the stock and sell it quickly if the stock price increases, or it can hold the stock for many years.
     • If the entity intends to sell the stock in a short period of time (less than a year), it is classified as a short-term investment.
     • Equity securities are generally recorded at fair value.
  2. Debt securities: investments in bonds or notes of other companies or governmental entities.
     • Debt investments are further separated into three portfolios for valuation and reporting purposes as follows.
       • Held-to-maturity: debt securities that a company intends to hold until maturity.
         • These are reported as current or noncurrent assets depending on the time left until maturity.
         • Held-to-maturity debt investments are reported on the balance sheet at “amortized cost."
       • Trading: debt securities bought and held primarily for sale in the near future to generate a return.
         • These are reported as current assets at their fair value.
       • Available-for-sale: debt securities not classified as held-to-maturity or trading securities.
         • These are reported at fair value as current or noncurrent assets depending on the length of time management intends to hold the investment.

ILLUSTRATION 4.6 Balance Sheet Presentation of Investments in Securities

• CVS Health Corporation (in millions)
  • Assets
    • Cash and cash equivalents: $5,683$
    • Short-term investments: $2,373$
  • Note 1 Accounting Policies (in part): Debt securities consist primarily of U.S. Treasury and agency securities, mortgage-backed securities, corporate and foreign bonds, and other debt securities. Debt securities are classified as either current or long-term investments based on their contractual maturities unless the company intends to sell an investment within the next twelve months, in which case it is classified as current on the consolidated balance sheets. Debt securities are classified as available for sale and are carried at fair value.
    Note 3 Investments (in part):
    Current
    Debt securities available for sale: $2,251$
    Mortgage loans: $122$
    Total current investments: $2,373$
• Receivables
  • Current receivables may be grouped as one item on the balance sheet and be shown “net” of any expected loss due to uncollectible amounts.
  • A breakdown of major categories of receivables is typically provided in the related notes.
  • For receivables arising from unusual transactions, such as sale of property or a loan to employees, companies should separately classify these as long-term unless collection is expected within one year.

ILLUSTRATION 4.7 Balance Sheet Presentation of Current Assets

• Stanley Black & Decker (in millions)
  • Current assets
    • Cash and cash equivalents: $297.7$
    • Accounts and notes receivable, net: $1,454.6$
    • Inventories, net: $2,255.0$
    • Prepaid expenses: $395.4$
    • Other current assets: $53.9$
    • Total current assets: $4,456.6$
  • Note B (in part): Accounts and Notes Receivable
    • Trade accounts receivable: $1,284.0$
    • Trade notes receivable: $156.7$
    • Other accounts receivables: $126.3$
    • Gross accounts and notes receivable: $1,567.0$
    • Allowance for doubtful accounts: $(112.4)$
      Accounts and notes receivable, net: $1,454.6$
• Inventories
  • To present inventories properly, a company discloses the basis of valuation (e.g., lower-of-cost-or-net realizable value or lower-of-cost-or-market) and the cost flow assumption used (e.g., FIFO or LIFO).
  • A manufacturing company also indicates the stage of completion of the inventories in the notes to its financial statements.

ILLUSTRATION 4.8 Note Disclosure of Inventories

• Stanley Black & Decker
  • Note C (in part): Inventories
    • Finished products: $1,526.0$
    • Work in process: $162.0$
    • Raw materials: $567.0$
    • Total: $2,255.0$
  • Note A (in part): Inventories
    • U.S. inventories are primarily valued at the lower of Last-In-First-Out (“LIFO”) cost or market because the Company believes it results in better matching of costs and revenues.
• Prepaid Expenses
  • A company includes prepaid expenses in current assets if it will receive benefits (usually services) within one year or the operating cycle, whichever is longer.
  • These items are current assets because if they had not already been paid, they would require the use of cash during the next year or the operating cycle.
  • A company reports prepaid expenses at the amount of the unexpired or unconsumed cost.
  • A common example is the prepayment for an insurance policy.
    • A company classifies it as a prepaid expense because the payment precedes the receipt of the benefit of coverage.
  • Other common prepaid expenses include prepaid rent, advertising, taxes, and office or operating supplies.

Analytics in Action: Working Capital and Analytics?

• Companies have access to more data than ever before and increasingly more tools to evaluate data for business decisions.
• Inventory Management: Granular data on inventory (how many days each type of inventory will last) is necessary to manage inventory levels effectively.
• Supplier Negotiations: Without data on how much is spent with each supplier, managers cannot negotiate volume discounts.
• Timely Invoicing: Collecting data on the timeliness of issuing sales invoices after services are provided will highlight any consistent delays.
  • You cannot expect to receive payment from your customers until you invoice them.
• Managing working capital with data can provide a lifeline to struggling companies and a significant competitive advantage to healthy companies.
  • One natural-resources company reduced its working capital by more than $40\%$ in the space of a year, worth almost $1.5$ billion!
• Noncurrent Assets
  • Noncurrent assets are those not meeting the definition of current assets. They include a variety of items.
• Long-Term Investments
  • Long-term investments, often referred to simply as investments, normally consist of one of four types.
    1. Investments in debt and equity securities.
    2. Investments in tangible fixed assets not currently used in operations, such as land held for speculation.
    3. Investments set aside in special funds, such as a sinking fund, pension fund, or plant expansion fund. This includes the cash surrender value of life insurance.
    4. Investments in nonconsolidated subsidiaries or affiliated companies.
  • Companies usually present long-term investments on the balance sheet just below “Current assets,” in a separate section called “Investments.”
  • Realize that many securities classified as long-term investments are, in fact, readily marketable.
    • But a company does not include them as current assets unless it intends to convert them to cash in the short-term—that is, within a year or in the operating cycle, whichever is longer.

ILLUSTRATION 4.9 Balance Sheet Presentation of Long-Term Investments

• CVS Health Corporation (in millions)
  • Assets
    • Total current assets: $50,302$
    • Long-term investments: $17,314$
  • Note 3 Investments (in part):
    Long-term
    Debt securities available for sale: $14,671$
    Mortgage loans: $1,091$
    Other investments: $1,552$
    Total investments: $17,314$
• Property, Plant, and Equipment
  • Property, plant, and equipment are tangible long-lived assets used in the regular operations of the business.
  • These assets consist of physical property such as land, buildings, machinery, furniture, tools, right-of-use assets (leased assets), and wasting resources (timberland, minerals).
  • The right-of-use asset results from leasing arrangements and can be significant for many companies, as most lease arrangements are recorded on the balance sheet.
  • With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., timberlands or oil reserves) these assets.

ILLUSTRATION 4.10 Balance Sheet Presentation of Property, Plant, and Equipment

• Mattel Inc.
  • Property, plant, and equipment, net: $550,139$
  • Right-of-use assets, net: $303,187$
  • Goodwill: $1,390,714$
  • Other noncurrent assets: $833,212$
  • $3,077,252$
• Note 2: Property, plant, and equipment, net includes the following:
  Land: $25,112$
  Buildings: $302,956$
  Machinery and equipment: $812,509$
  Software: $364,391$
  Tools, dies, and molds: $747,706$
  Leasehold improvements: $183,250$
• $2,435,924$
  Less: Accumulated depreciation: $1,885,785$
  Total property, plant, and equipment, net: $550,139$

Intangible assets

• Intangible assets lack physical substance and are not financial instruments.
• Intangible assets include patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists.
• A company writes off (amortizes) limited-life intangible assets over their useful lives.
• It periodically assesses indefinite-life intangibles (such as goodwill) for impairment.
• Intangible assets can represent significant economic resources, yet financial analysts often ignore them, because valuation is difficult.

ILLUSTRATION 4.11 Balance Sheet Presentation of Intangible Assets

• PepsiCo, Inc. (in millions)
  • Intangible assets
    • Amortizable Intangible Assets, net: $1,433$
    • Goodwill: $15,501$
    • Other indefinite-lived intangible assets: $14,610$
  • Total intangible assets: $31,544$
• You should recognize that a company like PepsiCo spends considerable sums (more than $1\%$ of sales) on research and development costs, which may lead to the development of patents or copyrights.
• However, due to the difficulty of associating these expenditures with possible intangible assets in the future, these costs are expensed as incurred.