ACTG 3110

Chapter 5 - The Balance Sheet and the Statement of Cash Flows

Overview

• Balance Sheet– Time period– What it represents (resources and claims)– Uses -

• Liquidity• Solvency• Financial Flexibility

– Limitations• Generally figures are based on historical cost • Does not represent net worth of company• Omits valuable resources (people)

Balance Sheet

• Assets -– Definition - Probable future economic benefits

obtained or controlled by a particular entity as a result of past transactions or events.

– Listed in order of liquidity– Generally valued at cost; some items valued at

fair market value or net realizable value– Designated as current or noncurrent

Balance Sheet

– Current - expected to be used up or converted to cash within one year or the operating cycle, whichever is longer

– Operating cycle – time to take cash and buy inventory and sell inventory and collect the money from the sale

– Examples – cash, accounts receivable, inventory, marketable securities, notes receivable, prepaid expenses

– Noncurrent assets - everything else

• Long-term Investments

• Property, plant and equipment

• Intangible assets

• Other assets

Balance Sheet

• Liabilities– Definition: 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.

– Listed in order of payment– Designated as current and long-term depending

on when to be paid

Balance Sheet• Liabilities

– Current liabilities often valued at maturity value• Must mature within one year or the operating cycle, whichever is longer

• Management must intend to eliminate them through the use of existing current assets or the creation of other current liabilities

• Working capital = current assets – current liabilities

• Examples: Accounts payable, Short-term notes payable, interest payable, income taxes payable

– Long-term - often valued at net present value• Examples: Bonds payable, Mortgage payable, Long-term lease

obligations, Long-term notes payable, deferred income taxes

• Contingencies

Balance Sheet

• Owner’s Equity– Represents net assets (Assets-liabilities)– Listed in order of permanence– Contributed capital

• Capital stock (par or stated value)• Additional paid-in capital (Excess of market value

over par/stated value)• Different classes of capital (preferred generally

listed first)

Balance Sheet

• Retained Earnings– Earnings kept in the business and not paid out since

the firm’s inception– Negative amounts are called “deficits”.

• Accumulated Other Comprehensive Income• Treasury Stock

– Repurchase of company’s own stock– Shown as a negative amount in stockholders’ equity

classification

Formats

• Account form

• Report form

• International differences– Formats– Terminology

Additional Information Reported

• Contingencies

• Accounting Policies

• Contractual Situations

• Fair values

• Notes to financial statements

• Supporting Schedules

Statement of Cash Flows

• Why do we have a statement of cash flows?

• What are the purposes?

• Is “Cash” necessary for survival?

• Solvency is one of the main objectives of a business

• Brief History

Cash

• Cash and cash equivalents

• Cash inflows

• Cash outflows

• Subtotal for net inflows

• Cash flows generally do not correspond to the general ledger

• General ledger is on the accrual basis

Classification

• Operating activities– Basically day-to-day transactions– Generally income statement items

• Investing activities– Generally involve long-term assets

• Financing activities– Generally notes payable, long-term liabilities,

and stockholders’ equity transactions

Operating Activities Indirect Method

• Starts with Net income on the accrual basis and determines cash flows from operating activities

• Net Income• Adjustments:

– Add back noncash expenses– Add/subtract changes in current assets and liabs– Add losses/subtract gains

• YIELDS THE SAME NET CASH FLOWS AS THE DIRECT METHOD

Investing Activities

• Inflows:– Sell property, plant and equipment– Sell long-term investments– Receive principal on note receivable

• Outflows:– Purchase long-term investments– Purchase property, plant, and equipment– Lend money

Financing Activities

• Inflows:– Issue stock– Issue bonds– Receive notes payable

• Outflows:– Pay back principal on notes payable– Purchase treasury stock– Pay cash dividends

Non-Cash Activities

• Activities which do not involve cash but which affect our investing and financing accounts

• Listed on a separate attachment

• Examples:– Purchase a building by issuing a note payable– Retire bonds by issuing common stock

Usefulness of the Statement of Cash Flows

• Financial liquidity– Net cash provided by operating activities/average current liabilities

= current cash debt coverage– Ratio of 1:1 is good

• Financial flexibility– Net cash provided by operating activities/average total liabilities =

cash debt coverage ratio– The higher the ratio, the better

• Free cash flow– Net cash provided by operating activities – capital expenditures –

dividends = free cash flow– The higher the amount, the better