Kế toán, kiểm toán - Balance sheet and statement of cash flows

PREVIEW OF CHAPTER 5Intermediate Accounting16th EditionKieso ● Weygandt ● Warfield Explain the uses and limitations of a balance sheet.Identify the major classifications of the balance sheet.Prepare a classified balance sheet using the report and account formats.Identify the purpose and content of the statement of cash flows.LEARNING OBJECTIVESPrepare a basic statement of cash flows.Understand the usefulness of the statement of cash flows.Determine which balance sheet information requires supplemental disclosure.Describe the major disclosure techniques for the balance sheet.After studying this chapter, you should be able to:Balance Sheet and Statement of Cash Flows5LO 1Balance Sheet, sometimes referred to as the statement of financial position:Reports assets, liabilities, and equity at a specific date.Provides information about resources, obligations to creditors, and equity in net resources.Helps in predicting amounts, timing, and uncertainty of future cash flows.BALANCE SHEETLO 1Computing rates of return.Evaluating the capital structure.Assess risk and future cash flows.Analyze the company’s: Liquidity, Solvency, and Financial flexibility.Usefulness of the Balance SheetBALANCE SHEETLO 1Most assets and liabilities are reported at historical cost.Use of judgments and estimates.Many items of financial value are omitted.Limitations of the Balance SheetBALANCE SHEETLO 1The terrorist attacks of September 11, 2001, showed how vulnerable the major airlines are to falling demand for their services. Since that infamous date, major airlines have reduced capacity and slashed jobs to avoid bankruptcy. United Airlines, Northwest Airlines, US Airways, and several smaller competitors filed for bankruptcy in the wake of 9/11. Delta Airlines made the following statements in its annual report issued shortly after 9/11:“If we are unsuccessful in further reducing our operating costs . . . we will need to restructure our costs under Chapter 11 of the U.S. Bankruptcy Code. . . . We have substantial liquidity needs and there is no assurance that we will be able to obtain the necessary financing to meet those needs on acceptable terms, if at all.”WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? GROUNDEDcontinuedLO 1These financial flexibility challenges have continued, exacerbated by volatile fuel prices, labor costs, and the unpredictability of the global economic environment. Not surprisingly, several of the major airlines (Delta and Northwest, Continental and United, Airtran and Southwest, and American Airlines and US Airways) merged recently as a way to build some competitive synergies and to bolster their financial flexibility. There is no question that running an airline is a difficult task. As superstar investor Warren Buffett said, “I have an 800 number now that I call if I get the urge to buy an airline stock,” adding that his “aeroholic” buddies “talk me down.”Sources: R. Seaney, “Airline Mergers: Good for Travelers?” (April 27, 2012); and T. Reed, “Buffett Decries Airline Investing Even Though at Worst He Broke Even,” Forbes (May 13, 2013).WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? GROUNDEDLO 1Explain the uses and limitations of a balance sheet.Identify the major classifications of the balance sheet.Prepare a classified balance sheet using the report and account formats.Identify the purpose and content of the statement of cash flows.LEARNING OBJECTIVESPrepare a basic statement of cash flows.Understand the usefulness of the statement of cash flows.Determine which balance sheet information requires supplemental disclosure.Describe the major disclosure techniques for the balance sheet.After studying this chapter, you should be able to:Balance Sheet and Statement of Cash Flows5LO 2Classification in the Balance SheetBALANCE SHEETLO 2ILLUSTRATION 5-1 Balance Sheet ClassificationsIn practice you usually see little departure from these major subdivisions.Classification in the Balance SheetBALANCE SHEETLO 2The correct order to present current assets isCash, accounts receivable, prepaid items, inventories.Cash, accounts receivable, inventories, prepaid items.Cash, inventories, accounts receivable, prepaid items.Cash, inventories, prepaid items, accounts receivable.Classification in the Balance SheetQuestionOrder of LiquidityLO 2Cash 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. Presented in the balance sheet in order of liquidity. Current assetsBALANCE SHEET – “Current Assets”ILLUSTRATION 5-2 Current Assets and Basis of ValuationLO 2LO 2Generally any monies available “on demand.”Cash equivalents - short-term highly liquid investments that mature within three months or less.Restrictions or commitments must be disclosed. CashBALANCE SHEET – “Current Assets”ILLUSTRATION 5-3Balance Sheet Presentation of Restricted CashILLUSTRATION 5-4Balance Sheet Presentation of Current and Noncurrent Restricted CashBALANCE SHEET – “Current Assets”CashLO 2PortfoliosTypeValuationClassificationHeld-to-MaturityDebtAmortized CostCurrent or NoncurrentTradingDebt or EquityFair ValueCurrentAvailable- for-SaleDebt or EquityFair ValueCurrent or NoncurrentShort-Term InvestmentsBALANCE SHEET – “Current Assets”LO 2Short-Term InvestmentsILLUSTRATION 5-5Balance Sheet Presentation of Investments in SecuritiesBALANCE SHEET – “Current Assets”LO 2Major categories of receivables should be shown in the balance sheet or the related notes.A company should clearly identify Anticipated loss due to uncollectibles.Amount and nature of any nontrade receivables.Receivables used as collateral.ReceivablesBALANCE SHEET – “Current Assets”LO 2LO 2ReceivablesILLUSTRATION 5-6Balance Sheet Presentation of ReceivablesBALANCE SHEET – “Current Assets”InventoriesDisclose: Basis of valuation (e.g., lower-of-cost-or-market). Cost flow assumption (e.g., FIFO or LIFO). BALANCE SHEET – “Current Assets”ILLUSTRATION 5-8Balance Sheet Presentation of Inventories, Showing Product LinesInventoriesILLUSTRATION 5-7Balance Sheet Presentation of Inventories, Showing Stage of CompletionBALANCE SHEET – “Current Assets”LO 2Payment of cash, that is recorded as an asset because service or benefit will be received in the future.insurancesuppliesadvertisingCash PaymentExpense RecordedBEFORErenttaxesPrepayments often occur in regard to:Prepaid ExpensesBALANCE SHEET – “Current Assets”LO 2Prepaid ExpensesILLUSTRATION 5-9Balance Sheet Presentationof Prepaid ExpensesBALANCE SHEET – “Current Assets”LO 2Summary 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. BALANCE SHEET – “Current Assets”LO 2Long-Term InvestmentsSecurities (bonds, common stock, or long-term notes).Tangible fixed assets not currently used in operations (land held for speculation).Special funds (sinking fund, pension fund, plant expansion fund, or cash surrender value of life insurance).Nonconsolidated subsidiaries or affiliated companies.Noncurrent AssetsClassification in the Balance SheetLO 2PortfoliosTypeValuationClassificationHeld-to-MaturityDebtAmortized CostCurrent or NoncurrentTradingDebt or EquityFair ValueCurrentAvailable- for-SaleDebt or EquityFair ValueCurrent or NoncurrentBALANCE SHEET – “Noncurrent Assets”Long-Term InvestmentsLO 2Long-Term InvestmentsBonds, Stock, and Long-term notesFor marketable securities, management’s intent determines current or noncurrent classification.SecuritiesBALANCE SHEET – “Noncurrent Assets”Land held for speculationBALANCE SHEET – “Noncurrent Assets”Fixed AssetsLong-Term InvestmentsSinking fundPensions fundCash surrender value of life insuranceBALANCE SHEET – “Noncurrent Assets”Special FundsLong-Term InvestmentsNonconsolidated Subsidiaries or Affiliated Companies BALANCE SHEET – “Noncurrent Assets”Long-Term InvestmentsILLUSTRATION 5-10Balance Sheet Presentation ofLong-Term InvestmentsLong-Term InvestmentsBALANCE SHEET – “Noncurrent Assets”LO 2Tangible long-lived assets used in the regular operations of the business. Physical property such as land, buildings, machinery, furniture, tools, and wasting resources (minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., oil reserves) these assets.Property, Plant, and EquipmentBALANCE SHEET – “Noncurrent Assets”LO 2Property, Plant, and EquipmentA company discloses the basis it uses to value property, plant, and equipment.BALANCE SHEET – “Noncurrent Assets”LO 2ILLUSTRATION 5-11Balance Sheet Presentation of Property, Plant, and EquipmentProperty, Plant, and EquipmentBALANCE SHEET – “Noncurrent Assets”LO 2LO 2Intangible AssetsLack physical substance and are not financial instruments.Limited life intangibles amortized.Indefinite-life intangibles tested for impairment.BALANCE SHEET – “Noncurrent Assets”Illustration: Patrick Corporation adjusted trial balance contained the following asset accounts at December 31, 2017: Prepaid Rent $12,000; Goodwill $50,000; Franchise Fees Receivable $2,000; Franchises $47,000; Patents $33,000; Trademarks $10,000. Prepare the intangible assets section of the balance sheet.Intangible Assets Goodwill $ 50,000Franchises 47,000Patents 33,000Trademarks 10,000Total $140,000BALANCE SHEET – “Noncurrent Assets”LO 2Intangible AssetsILLUSTRATION 5-12Balance Sheet Presentation of Intangible AssetsBALANCE SHEET – “Noncurrent Assets”LO 2Other AssetsItems vary in practice. Can includeLong-term prepaid expensesNon-current receivablesAssets in special fundsDeferred income taxesProperty held for saleRestricted cash or securitiesBALANCE SHEET – “Noncurrent Assets”LO 2LO 2Other AssetsThis section should include only unusual items sufficiently different from assets in the other categories.BALANCE SHEET – “Noncurrent Assets”Before the dot-com bubble burst, concerns about liquidity and solvency led creditors of many dot-com companies to demand more assurances that these companies could pay their bills when due. A key indicator for creditors is the amount of working capital. For example, when a report predicted that Amazon. com’s working capital would turn negative, the company’s vendors began to explore steps that would ensure that Amazon would pay them.Some vendors demanded that their dot-com customers sign notes stating that the goods shipped to them would serve as collateral for the transaction. Other vendors began shipping goods on consignment—an arrangement whereby the vendor retains ownership of the goods until a third party buys and pays for them. Another recent bubble in the real estate market created a working capital and liquidity crisis for no less a revered financial institution than Bear Stearns. What happened? Bear WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? “SHOW ME THE ASSETS!”continuedLO 2Stearns was one of the biggest investors in mortgage-backed securities. But when the housing market cooled off and the value of the collateral backing Bear Stearns’ mortgage securities dropped dramatically, the market began to question Bear Stearns’ ability to meet its obligations. The result: The Federal Reserve stepped in to avert a collapse of the company, backing a bailout plan that guaranteed $30 billion of Bear Stearns’ investments. This paved the way for a buy-out by JPMorgan Chase at $2 per share (later amended to $10 a share)—quite a bargain since Bear Stearns had been trading above $80 a share just a month earlier.Source: Robin Sidel, Greg Ip, Michael M. Phillips, and Kate Kelly, “The Week That Shook Wall Street: Inside the Demise of Bear Stearns,” Wall Street Journal (March 18, 2008), p. A1.WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? “SHOW ME THE ASSETS!”LO 2Companies classify liabilities as current or long-term.Classification in the Balance SheetLiabilitiesLO 2Obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities.Current LiabilitiesBALANCE SHEET – “Liabilities”LO 2Current LiabilitiesILLUSTRATION 5-13Balance Sheet Presentation of Current LiabilitiesBALANCE SHEET – “Liabilities”LO 2Obligations that a company does not reasonably expect to liquidate within the normal operating cycle.All covenants and restrictions must be disclosed.Long-Term LiabilitiesBALANCE SHEET – “Liabilities”LO 2Illustration: Included in Adams Company’s December 31, 2017, trial balance are the following accounts: Accounts Payable $220,000; Pension Asset/Liability $375,000; Discount on Bonds Payable $29,000; Unearned Revenue $41,000; Bonds Payable $400,000; Salaries and Wages Payable $27,000; Interest Payable $12,000; Income Taxes Payable $29,000. Prepare the long-term liabilities section of the balance sheet.Long-term liabilities Pension Asset/liability $375,000Bonds payable 400,000Discount on bonds payable (29,000)Total $746,000BALANCE SHEET – “Liabilities”LO 2Long-Term LiabilitiesILLUSTRATION 5-14Balance Sheet Presentation of Long-Term LiabilitiesBALANCE SHEET – “Liabilities”LO 2Owners’ EquityClassification in the Balance SheetLO 2ILLUSTRATION 5-15Balance Sheet Presentation of Stockholders’ EquityOwners’ EquityClassification in the Balance SheetLO 2(a) Investment in preferred stockAccount(b) Treasury stock(c) Common stock(d) Cash dividends payable(e) Accumulated depreciation(f) Interest payable(g) Deficit(h) Trading securities(i) Unearned revenue(a) Current asset/Investment(b) Stockholders’ Equity (c) Stockholders’ Equity (d) Current liability(e) Contra-asset(f) Current liability(g) Stockholders’ Equity(h) Current asset(i) Current liabilityClassificationClassification in the Balance SheetLO 2LO 2Analysts use balance sheet information in models designed to predict financial distress. Researcher E. I. Altman pioneered a bankruptcy-prediction model that derives a “Z-score” by combining balance sheet and income measures in the following equation. Following extensive testing, Altman found that companies with Z-scores above 3.0 are unlikely to fail. Those with Z-scores below 1.81 are very likely to fail. Altman developed the original model for publicly held manufacturing companies. He and others have modified the model to apply to companies in various industries, emerging companies, and companies not traded in public markets.WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? WARNING SIGNALScontinuedAt one time, the use of Z-scores was virtually unheard of among practicing accountants. Today, auditors, management consultants, and courts of law use this measure to help evaluate the overall financial position and trends of a firm. In addition, banks use Z-scores for loan evaluation. While a low score does not guarantee bankruptcy, the model has been proven accurate in many situations.Source: Adapted from E. I. Altman and E. Hotchkiss, Corporate Financial Distress and Bankruptcy, Third Edition (New York: John Wiley and Sons, 2006).WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? WARNING SIGNALSLO 2Explain the uses and limitations of a balance sheet.Identify the major classifications of the balance sheet.Prepare a classified balance sheet using the report and account formats.Identify the purpose and content of the statement of cash flows.LEARNING OBJECTIVESPrepare a basic statement of cash flows.Understand the usefulness of the statement of cash flows.Determine which balance sheet information requires supplemental disclosure.Describe the major disclosure techniques for the balance sheet.After studying this chapter, you should be able to:Balance Sheet and Statement of Cash Flows5LO 3Classified Balance SheetAccount formReport formBalance Sheet FormatAccounting Trends and Techniques (New York: AICPA) indicates that all of the 500 companies surveyed use either the “report form” (484) or the “account form” (16), sometimes collectively referred to as the “customary form.”LO 3Report FormILLUSTRATION 5-16Classified Report Form Balance SheetBalance Sheet FormatSCIENTIFIC PRODUCTS, INCBalance SheetDecember 31, 2017UNDERLYING CONCEPTS The presentation of balance sheet information meets the objective of financial reporting—to provide information about entity resources, claims to resources, and changes in them.LO 3Explain the uses and limitations of a balance sheet.Identify the major classifications of the balance sheet.Prepare a classified balance sheet using the report and account formats.Identify the purpose and content of the statement of cash flows.LEARNING OBJECTIVESPrepare a basic statement of cash flows.Understand the usefulness of the statement of cash flows.Determine which balance sheet information requires supplemental disclosure.Describe the major disclosure techniques for the balance sheet.After studying this chapter, you should be able to:Balance Sheet and Statement of Cash Flows5LO 4STATEMENT OF CASH FLOWSThe income statement, the statement of stockholders’ equity, and the balance sheet—each present SOME information about the cash flows of an enterprise during a period.The statement of cash flows presents a DETAILED SUMMARY of all the cash inflows and outflows, or the sources and uses of cash during the period.UNDERLYING CONCEPTS The statement of cash flows meets the objective of financial reporting—to help assess the amounts, timing, and uncertainty of future cash flows.LO 4To provide relevant information about the cash receipts and cash payments of an enterprise during a period. The statement provides answers to the following questions:Where did the cash come from?What was the cash used for?What was the change in the cash balance?Purpose of the Statement of Cash FlowsSTATEMENT OF CASH FLOWSLO 4Investors usually focus on net income measured on an accrual basis. However, information on cash flows can be important for assessing a company’s liquidity, financial flexibility, and overall financial performance. The graph below shows W. T. Grant’s financial performance over 7 years. Although W. T. Grant showed consistent profits and even some periods ofWHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? WATCH THAT CASH FLOWcontinuedearnings growth, its cash flow began to “go south” starting in about year 3. The company filed for bankruptcy shortly after year 7. Financial statement readers who studied the company’s cash flows would have found early warnings of its problems. The Grant experience is a classic case, illustrating the importance of cash flows as an early-warningLO 4signal of financial problems. The recent picture at IBM is similar and raises some red flags as to the company’s financial flexibility. As shown in the following chart, IBM’s earnings per share (EPS) growth has held steady, but growth in free cash flow is on the decline. A look under the hoodWHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? WATCH THAT CASH FLOWindicates that while debt levels are increasing, IBM has been using free cash flow for increased dividends and share buybacks. Recall that buybacks increase EPS by reducing shares outstanding. However, some analysts believe that many of the funds should be allocated to R&D. That is, free cash flow going toward dividends and share repurchases indicates IBM’s “low quality of earnings.”Source: A. Shields, “Why IBM Has Generated Higher Earnings Despite Falling Revenue,” Market Realist, (July 11, 2014).Three different activities:Operating, Content and FormatInvesting,FinancingILLUSTRATION 5-17Basic Format of CashFlow StatementSTATEMENT OF CASH FLOWSLO 4FinancingObtaining resources from owners and providing them with a return on their investment, and borrowing money from creditors and repaying the amounts borrowed.OperatingCash effects of transactions that enter into the determination of net income.Making and collecting loans and acquiring and disposing of investments and property, plant, and equipment.Content and FormatInvestingSTATEMENT OF CASH FLOWSLO 4LO 4STATEMENT OF CASH FLOWSILLUSTRATION 5-18 Cash Inflows and OutflowsExplain the uses and limitations of a balance sheet.Identify the major classifications of the balance sheet.Prepare a classified balance sheet using the report and account formats.Identify the purpose and content of the statement of cash flows.LEARNING OBJECTIVESPrepare a basic statement of cash flows.Understand the usefulness of the statement of cash flows.Determine which balance sheet information requires supplemental disclosure.Describe the major disclosure techniques for the balance sheet.After studying this chapter, you should be able to:Balance Sheet and Statement of Cash Flows5LO 5Information obtained from several sources: comparative balance sheets, the current income statement, and selected transaction data. Overview of the Preparation of the StatementSTATEMENT OF CASH FLOWSLO 5Illustration: On January 1, 2017, in its first year of operations, Telemarketing Inc. issued 50,000 shares of $1 par value common stock for $50,000 cash. The company rented its office space, furniture, and telecommunications equipment and performed marketing services throughout the first year. In June 2017 the company purchased land for $15,000. ILLUSTRATION 5-19 shows the company’s comparative balance sheets at the beginning and end of 2017.STATEMENT OF CASH FLOWSLO 5ILLUSTRATION 5-19ILLUSTRATION 5-20Preparing the Statement of Cash FlowsFour steps: Determine the net cash provided by (or used in) operating activities.Determine the net 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.STATEMENT OF CASH FLOWSLO 5Cash provided by operating activitiesILLUSTRATION 5-19ILLUSTRATION 5-20ILLUSTRATION 5-21STATEMENT OF CASH FLOWSLO 5STATEMENT OF CASH FLOWSILLUSTRATION 5-22Next, the company determines its investing and financing activities.ILLUSTRATION 5-19ILLUSTRATION 5-20Illustration: Keyser Beverage Company reported the following items in the most recent year.ActivityOperatingFinancingOperatingOperatingInvestingOperatingFinancingRequired: Compute net cash provided by operating activities.Net income $40,000Dividends paid 5,000Increase in accounts receivable 10,000Increase in accounts payable 5,000Purchase of equipment 8,000Depreciation expense 40,000Issue of notes payable 20,000STATEMENT OF CASH FLOWSLO 5Noncash charge to expenses.Noncash credit to revenues.STATEMENT OF CASH FLOWSLO 5QuestionIn preparing a statement of cash flows, which of the following transactions would be considered an investing activity? a. Sale of equipment at book value b. Sale of merchandise on credit c. Declaration of a cash dividend d. Issuance of bonds payable at a discount.STATEMENT OF CASH FLOWSLO 5Issuance of common stock to purchase assets.Conversion of bonds into common stock.Issuance of debt to purchase assets.Exchanges on long-lived assets.Significant financing and investing activities that do not affect cash are reported in either a separate schedule at the bottom of the statement of cash flows or in the notes. Examples include:Significant Noncash ActivitiesSTATEMENT OF CASH FLOWSLO 5LO 5ILLUSTRATION 5-23Comprehensive Statement of Cash FlowsExplain the uses and limitations of a balance sheet.Identify the major classifications of the balance sheet.Prepare a classified balance sheet using the report and account formats.Identify the purpose and content of the statement of cash flows.LEARNING OBJECTIVESPrepare a basic statement of cash flows.Understand the usefulness of the statement of cash flows.Determine which balance sheet information requires supplemental disclosure.Describe the major disclosure techniques for the balance sheet.After studying this chapter, you should be able to:Balance Sheet and Statement of Cash Flows5LO 6High amount – company is able to generate sufficient cash to pay its bills.Low amount - company may have to borrow or issue equity securities to pay bills.Without cash, a company will not survive. Cash flow from Operations:Usefulness of the Statement of Cash FlowsSTATEMENT OF CASH FLOWSLO 6Usefulness of the Statement of Cash FlowsRatio indicates whether the company can pay off its current liabilities from internally generated cash flows. A ratio near 1:1 is good.Financial LiquidityNet Cash Provided by Operating ActivitiesAverage Current Liabilities Current Cash Debt Coverage Ratio =ILLUSTRATION 5-25 Formula for Current Cash Debt Coverage LO 6Net Cash Provided by Operating ActivitiesAverage Total Liabilities Cash Debt Coverage Ratio =Financial FlexibilityUsefulness of the Statement of Cash FlowsILLUSTRATION 5-26Formula for Cash Debt CoverageThis ratio indicates a company’s ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations.LO 6The amount of discretionary cash flow a company has that may be used for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity.ILLUSTRATION 5-28 Free Cash Flow ComputationFree Cash FlowUsefulness of the Statement of Cash FlowsLO 6The current cash debt coverage ratio is often used to assess a. financial flexibility. b. liquidity. c. profitability. d. solvency.Usefulness of the Statement of Cash FlowsQuestionLO 6As one manager noted, “There ought to be a law that before you can buy a stock, you must be able to read a balance sheet.” We agree, and the same can be said for a statement of cash flows. Krispy Kreme Doughnuts provides an example of how stunning earnings growth can hide real problems. Not long ago, the doughnut maker was a glamour stock with a 60 percent earnings per share growth rate and a price-earnings ratio around 70. Seven months later, its stock price had dropped 72 percent. What happened? Stockholders alleged that Krispy Kreme may have been inflating its revenues and not taking enough bad debt expense (which inflated both assets and income). In addition, Krispy Kreme’s operating cash flow was negative. Most financially sound companies generate positive cash flow. The following are additional examples of how one rating agency rated the earnings quality of some companies, using some key balance sheet and statement of cash flow measurements. Another rating organization uses a metric to adjust for shortcomings in amounts reported in the balance sheet. WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? “THERE OUGHT TO BE A LAW”continuedLO 6Just as improving balance sheet and cash flow information is a leading indicator of improved earnings, a deteriorating balance sheet and statement of cash flows warn of earnings declines (and falling stock prices). This was the case at Avon; its strong cash flow rating subsequently declined, such that its free cash flow was just 76 percent of net income. This raised red flags about the results on foreign investments by Avon.Sources: Adapted from Gretchen Morgenson, “How Did They Value Stocks? Count the Absurd Ways,” New York Times on the Web (March 18, 2001); K. Badanhausen, J. Gage, C. Hall, and M. Ozanian, “Beyond Balance Sheet: Earnings Quality,” Forbes.com (January 28, 2005); and H. Karp, “Avon’s Investments Fall Short,” Wall Street Journal (December 8, 2011).WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? “THERE OUGHT TO BE A LAW”Explain the uses and limitations of a balance sheet.Identify the major classifications of the balance sheet.Prepare a classified balance sheet using the report and account formats.Identify the purpose and content of the statement of cash flows.LEARNING OBJECTIVESPrepare a basic statement of cash flows.Understand the usefulness of the statement of cash flows.Determine which balance sheet information requires supplemental disclosure.Describe the major disclosure techniques for the balance sheet.After studying this chapter, you should be able to:Balance Sheet and Statement of Cash Flows5LO 7Four types of information that are supplemental to account titles and amounts presented in the balance sheet:ADDITIONAL INFORMATIONSupplemental DisclosuresLO 7Explain the uses and limitations of a balance sheet.Identify the major classifications of the balance sheet.Prepare a classified balance sheet using the report and account formats.Identify the purpose and content of the statement of cash flows.LEARNING OBJECTIVESPrepare a basic statement of cash flows.Understand the usefulness of the statement of cash flows.Determine which balance sheet information requires supplemental disclosure.Describe the major disclosure techniques for the balance sheet.After studying this chapter, you should be able to:Balance Sheet and Statement of Cash Flows5LO 8Parenthetical ExplanationsNotesCross-Reference and Contra ItemsSupporting SchedulesTerminologyADDITIONAL INFORMATIONTechniques of DisclosureLO 8Techniques of DisclosureParenthetical ExplanationsILLUSTRATION 5-31 Parenthetical Disclosure of Shares Issued—Ford Motor CompanyLO 8Techniques of DisclosureNotesILLUSTRATION 5-32Note DisclosureLO 8Techniques of DisclosureCross-ReferenceILLUSTRATION 5-34Cross-ReferencingLO 8Techniques of DisclosureContra ItemsA contra account on a balance sheet reduces either an asset, liability, or owners’ equity account. Examples include Accumulated Depreciation—Equipment and Discount on Bonds Payable. An adjunct account increases either an asset, liability, or owners’ equity account. An example is Premium on Bonds Payable.LO 8Supporting SchedulesILLUSTRATION 5-35Disclosure through Use of Supporting SchedulesIn addition to the issue of financial statement presentation discussed in the opening story, a second area of controversy for balance sheet reporting is the issue of offsetting (or netting) of assets and liabilities. It is generally accepted that offsetting of recognized assets and recognized liabilities detracts from the ability of users both to understand the transactions and conditions that have occurred and to assess the company’s future cash flows. In other words, providing information on assets, liabilities, and stockholders’ equity helps users to compute rates of return and evaluate capital structure. However, netting assets and liabilities can limit a user’s ability to assess the future economic benefits and obligations. That is, offsetting hides the existence of assets and liabilities, making it difficult to evaluate liquidity, solvency, and financial flexibility. As a result, GAAP does not permit the reporting of summary accounts alone (e.g., total assets, net assets, and total liabilities). Recently, the IASB and FASB have worked to develop common criteria for offsetting on the balance sheet. Current offsetting rules under IFRS are more restrictive than GAAP. The rules proposed would allow offsetting only in rare circumstances (e.g., when right of offset is legally enforceable). Implementation of these newWHAT’S YOUR PRINCIPLEEVOLVING ISSUE BALANCE SHEET REPORTING: GROSS OR NET?continuedLO 8rules in the United States would result in a dramatic “grossing up” of balance sheets (particularly for financial institutions). For example, one study estimated that the new rules would gross up U.S. banks’ balance sheets by $900 billion (or an average of 68%, ranging from a 31.4% increase for Citigroup to 104.7% for Morgan Stanley).* Not surprisingly, the FASB received significant push-back from some of its constituents (particularly financial institutions) to the proposed rules. As a result, to date the Boards have not been able to agree on a converged standard, thereby stalling this project. However, the Boards have issued converged disclosure requirements. The disclosure rules require companies to disclose both gross information and net information about instruments and transactions that are eligible for offset in the balance sheet. While the Boards have not been able to develop a converged set of criteria for offsetting, the information provided under the new converged disclosure rules should enable users of a company’s financial statements to evaluate the effects of netting arrangements on its financial position. In doing so, the new rules support the full disclosure principle.*See Y. N’Diaye, “S&P: Accounting Rule Could Boost Bank Balance Sheets by Average 68%,” https://mninews.deutsche-boerse.com (September 22, 2011).WHAT’S YOUR PRINCIPLEEVOLVING ISSUE BALANCE SHEET REPORTING: GROSS OR NET?LO 9 Identify the major types of financial ratios and what they measure.USING RATIOS TO ANALYZE PERFORMANCEAnalysts and other interested parties can gather qualitative information from financial statements by examining relationships between items on the statements and identifying trends.APPENDIX 5ARATIO ANALYSIS—A REFERENCEAPPENDIX 5ARATIO ANALYSIS—A REFERENCERATIO ANALYSISILLUSTRATION 5A-1 A Summary of Financial RatiosLO 9APPENDIX 5ARATIO ANALYSIS—A REFERENCEILLUSTRATION 5A-1 A Summary of Financial RatiosRATIO ANALYSISLO 9APPENDIX 5ARATIO ANALYSIS—A REFERENCEILLUSTRATION 5A-1 A Summary of Financial RatiosRATIO ANALYSISLO 9Both IFRS and GAAP allow the use of title “balance sheet” or “statement of financial position.” IFRS recommends but does not require the use of the title “statement of financial position” rather than balance sheet.Both IFRS and GAAP require disclosures about (1) accounting policies followed, (2) judgments that management has made in the process of applying the entity’s accounting policies, and (3) the key assumptions and estimation uncertainty that could result in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. Comparative prior period information must be presented and financial statements must be prepared annually.IFRS and GAAP require presentation of non-controlling interests in the equity section of the balance sheet.LO 10 Compare the accounting procedure related to the balance sheet under GAAP and IFRS.RELEVANT FACTS - SimilaritiesIFRS requires a classified statement of financial position except in very limited situations. IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities. However under GAAP, public companies must follow SEC regulations, which require specific line items. Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last. IFRS has many differences in terminology. For example in the equity section common stock is called share capital—ordinary.Use of the term “reserve” is discouraged in GAAP, but there is no such prohibition in IFRS.RELEVANT FACTS - DifferencesLO 10The FASB and the IASB are working on a project to converge their standards related to financial statement presentation. A key feature of the proposed framework is that each of the statements will be organized, in the same format, to separate an entity’s financing activities from its operating and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the statement of comprehensiveincome and the statement of cash flows. The project has three phases. Youcan follow the joint financial presentation project at the following link: presentation.shtml.ON THE HORIZONLO 10Current assets under IFRS are listed generally:by importance.in the reverse order of their expected conversion to cash.by longevity.alphabetically.IFRS SELF-TEST QUESTIONLO 10Companies that use IFRS:may report all their assets on the statement of financial position at fair value.are not allowed to net assets (assets - liabilities) on their statement of financial positions.may report non-current assets before current assets on the statement of financial position.do not have any guidelines as to what should be reported on the statement of financial position.IFRS SELF-TEST QUESTIONLO 10A company has purchased a tract of land and expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. Under IFRS, the land should be reported as: land expense.property, plant, and equipment.an intangible asset.a long-term investment.IFRS SELF-TEST QUESTIONLO 10“Copyright © 2016 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”COPYRIGHT