This chapter describes the preparation of the balance sheet and statement of cash flows, which are topics covered on the CPA exam.
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Chapter 5 presents a detailed discussion of the concepts and techniques that underlie the preparation and analysis of the balance sheet. Along with the mechanics of preparation, acceptable disclosure requirements are examined and illustrated. A brief introduction to the statement of cash flows is also presented. This explanation serves as a foundation for the more comprehensive discussion of this subject presented in Chapter 23. At the end of Chapter 5, a multi-page illustration of the financial statements and accompanying notes
of a corporation are presented. This illustration may be referred to throughout the study of intermediate accounting as it includes information relevant to many of the topics discussed in subsequent chapters.
Usefulness of the Balance Sheet
For many years financial statement users generally considered the income statement to be superior to the balance sheet as a basis for judging the economic well-being of an enterprise. However, the balance sheet can be a very useful financial statement. If a balance sheet is examined carefully, users can gain a considerable amount of information used to assess liquidity, solvency and financial flexibility. Liquidity is generally related to the amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid. Solvency refers to the ability of an enterprise to pay its debts as they mature. Financial flexibility is the ability of an enterprise to take effective action to alter the amounts and timing of cash flow so that it can respond to unexpected needs and opportunities.
Limitations of the Balance Sheet
Criticism of the balance sheet has revolved around the limitations of the information presented therein. These limitations include:
(a) Failure to reflect current fair value information.
(b) The extensive use of judgment and estimates.
(c) Failure to include items of financial value that cannot be recorded objectively.
The problem with current value information concerns the reliability of such information. Where Level 1 estimates of fair value are not available, the estimation process involved in developing fair value information raises concern about the objectivity of the resulting information.
The use of estimates is extensive in the development of balance sheet data. These estimates are required by generally accepted accounting principles, but reflect a limitation of the balance sheet. The limitation concerns the fact that the estimates are only as good as the understanding and objectivity of the person(s) making the estimates.
The final limitation of the balance sheet concerns the fact that some significant assets of the entity are not recorded. Items such as human resources (employee workforce), managerial skills, customer base, and reputation are not recorded because such assets are difficult to quantify.
Classification in the Balance Sheet
The major classifications used in the balance sheet are assets, liabilities, and equity.
To provide the financial statement reader with additional information, these major classifications are divided into several subclassifications. Assets are further classified as current or noncurrent, with the noncurrent divided among long-term investments; property, plant, and equipment; intangible assets; and other assets. Liabilities are classified as current or noncurrent. Equity includes capital stock, additional paid-in capital, and retained earnings.
Assets. Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
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.
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.
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. Current assets are presented in the balance sheet in the order of their liquidity and normally include cash and cash equivalents, short-term investments, receivables, inventories, and prepaid expenses. There are some exceptions to a literal interpretation of the current asset definition. These exceptions involve prepaid expenses, investments in common stock, and the subsequent years’ depreciation of fixed assets. These exceptions are recognized in the accounting process and are understood by most financial statement users.
Reporting Current Assets
Any restrictions on the general availability of cash or any commitments on its probable disposition must be disclosed. Short-term investments are usually categorized as held-to-maturity, trading, or available-for-sale. Any anticipated loss due to uncollectibles, the amount and nature of any nontrade receivables, and any receivables designated as collateral should be clearly identified. For a proper presentation of inventories, the basis of valuation (i.e., lower of cost or market) and the method of pricing (FIFO or LIFO) should be disclosed. A company includes prepaid expenses in current assets if it will receive benefits within one year or the operating cycle, whichever is longer.
Items classified as long-term investments in the assets section of the balance sheet normally are one of four types. These include:
- Investments in securities, such as common stock, bonds, or long-term notes.
- Investments in tangible fixed assets not currently used in operations.
- Investments set aside in special funds (sinking, pension, plant expansion, etc.) and the cash surrender value of life insurance.
- Investments in nonconsolidated subsidiaries or affiliated companies.
Long-term investments are rather permanent in nature as they are not normally disposed of for a long period of time. They are shown in the balance sheet below current assets in a separate section called Investments.
Property, Plant and Equipment
Property, plant and equipment are properties of a durable nature that are used in the regular operations of the enterprise. Examples include land, land improvements, buildings, machinery, furniture, tools, and wasting resources. With the exception of land, these assets are either depreciable or depletable.
Intangible assets lack physical substance. However, their benefit lies in the rights they convey to the holder. Examples include patents, copyrights, franchises, goodwill, trademarks, trade names, and secret processes.
Limited-life intangible assets are amortized over their useful lives. Indefinite-life intangibles (such as goodwill) are not amortized but, instead, are assessed at least annually for impairment.
Many companies include an “Other Assets” classification in the balance sheet after Intangible Assets. This section includes a wide variety of items that do not appear to fall clearly into one of the other classifications. Some of the more common items included in this section are: deferred charges, noncurrent receivables, prepaid pension costs, deferred income taxes, and advances to subsidiaries.
Current liabilities are the obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities. Items normally shown in the current liabilities section of the balance sheet include notes and accounts payable, advances received from customers, current maturities of long-term debt, taxes payable, and accrued liabilities. Obligations due to be paid during the next year may be excluded from the current liability section if the item is expected to be refinanced through long-term debt or the item will be paid out of noncurrent assets.
Working capital is the excess of current assets over current liabilities. This concept, sometimes referred to as net working capital, represents the net amount of a company’s relatively liquid resources.
Long-term liabilities are obligations whose settlement dates extend beyond the normal operating cycle or one year, whichever is longer. Examples include bonds payable, notes payable, lease obligations, and pension obligations. Generally, the disclosure requirements for long-term liabilities are quite substantial as a result of various covenants and restrictions included for the protection of the lenders. Long-term liabilities that mature within the current operating cycle are classified as current liabilities if their liquidation requires the use of current assets. Long-term liabilities generally fall into one of the three following categories:
- Obligations arising from specific financing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable.
- Obligations arising from the ordinary operations of the company, such as pension obligations and deferred income tax liabilities.
- Obligations that depend on the occurrence or non-occurrence of one or more future events to confirm the amount payable, the payee, or the date payable, such as product warranties and other contingencies.
The owners’ equity (stockholders’ equity) section of the balance sheet includes information related to capital stock, additional paid-in capital, retained earnings and accumulated other comprehensive income. Preparation of the owners’ equity section should be approached with caution because of the various restrictions imposed by state corporation laws, liability agreements, and voluntary actions of the board of directors.
Balance Sheet Format
The account format of a classified balance sheet lists assets by sections on the left side and liabilities and stockholders’ equity by sections on the right side. The report format lists liabilities and stockholders’ equity directly below assets on the same page.
Statement of Cash Flows
The primary purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. The statement of cash flows answers three questions:
- Where did the cash come from during the period?
- What was the cash used for during the period?
- What was the change in the cash balance during the period?
In accomplishing its purpose, the statement focuses attention on three different activities related to cash flows.
- Operating activities involve the cash effects of transactions that enter into determination of net income.
- Investing activities include making and collecting loans and acquiring and disposing of debt and equity investments and property, plant, and equipment.
- Financing activities involve liability and owners’ equity items and include (1) obtaining resources from owners and providing them with a return on their investment and (2) borrowing money from creditors and repaying the amounts borrowed.
The basic format of the statement of cash flows is shown below.
Statement of Cash Flows
Cash flows from operating activities…………….. $XXX
Cash flows from investing activities…………….. XXX
Cash flows from financing activities…………….. XXX
Net increase (decrease) in cash…………………. XXX
Cash at beginning of year…………………………. XXX
Cash at end of year…………………………………. $XXX
The statement of cash flow’s value is that it helps users evaluate liquidity, solvency, and financial flexibility.
The information to prepare the statement of cash flows comes from three sources: (a) comparative balance sheets, (b) the current income statement, and (c) selected transaction data. Preparation of the statement of cash flows involves the following steps.
- Determine the cash provided by operations.
- Determine the cash provided by or used in investing and financing activities.
- Determine the change (increase or decrease) in cash during the period.
- Reconcile the change in cash with the beginning and the ending cash balances.
The information included in this chapter on the preparation of the statement of cash flows provides a basic introduction to the concepts involved. A complete and detailed presentation of the statement of cash flows is found in Chapter 23 of the text.
Usefulness of the Statement of Cash Flows
Creditors look for answers to the following questions in the company’s cash flow statement:
- How successful is the company in generating net cash provided by operating activities?
- What are the trends in net cash flow provided by operating activities over time?
- What are the major reasons for the positive or negative net cash provided by operating activities?
The current cash debt coverage indicates whether the company can pay off its current liabilities from its operations in a given year.
|Net Cash Provided by Operating Activities||=||Current Cash Debt Coverage|
|Average Current Liabilities|
The cash debt coverage measures a company’s ability to repay its liabilities from net cash provided by operating activities.
|Net Cash Provided by Operating Activities||=||Cash Debt Coverage|
|Average Total Liabilities|
Free Cash Flow
Free cash flow is the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity.
|Net Cash Provided by Operating Activities||–||Capital Expenditures||–||Dividends||= Free Cash Flow|
Supplemental disclosures related to contingencies, accounting policies, contractual situations, and fair values provide for elaboration or qualification of items listed in the balance sheet.
A contingency is an existing situation involving uncertainty as to a possible gain (gain contingency) or loss (loss contingency) that will ultimately be resolved when one or more future events occur or fail to occur. In short, they are uncertain occurrences that may have a material effect on financial position.
The methods used to value assets and allocate costs vary considerably among balance sheet accounts. To help users of the financial statements understand and evaluate financial statement components and their relationships, these valuation methods are normally disclosed in a separate Summary of Significant Accounting Policies preceding the financial statement notes. In addition to contingencies and valuation methods, any contractual situations of significance should be disclosed. These items include pension obligations, lease contracts, stock options, etc.
Financial instruments are defined as cash, an ownership interest, or a contractual right to receive, or an obligation to deliver cash or another financial instrument. Companies are to follow a fair value hierarchy that provides insight into how to determine fair values. Level 1 (the most reliable) measures are based on observable inputs, such as market price for identical assets or liabilities. Level 2 (less reliable) measures are based on market-based inputs other than those included in Level 1, such as those based on market prices for similar assets or liabilities. Level 3 (least reliable) measures are based on unobservable inputs, such as a company’s own data or assumptions. In addition, companies must provide significant additional disclosure related to Level 3 measurements.
Techniques of Disclosure
Effective communication of the information required to be disclosed in financial statements is an important consideration. Accountants have developed certain methods that have proven useful in disclosing pertinent information. The methods are parenthetical explanations, notes, cross-reference and contra items, and supporting schedules. Numerous examples of the techniques of disclosure are presented in the text.
The balance sheet should contain descriptive labels that readers will generally understand and clearly interpret. The profession has recommended that companies use the work ‘reserve’ only to describe an appropriation of retained earnings. In addition, the profession has recommended that the use of the work ‘surplus’ be discontinued in the equity section of the balance sheet.