978-1259722660 Chapter 3 Lecture Note Part 1

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CHAPTER 3

THE BALANCE SHEET AND FINANCIAL DISCLOSURES

Overview

Chapter 1 stressed the importance of the financial statements in helping investors and creditors

predict future cash flows. The balance sheet, along with accompanying disclosures, provides relevant

information useful in helping investors and creditors not only to predict future cash flows, but also to

make the related assessments of liquidity and long-term solvency.

The purpose of this chapter is to provide an overview of the balance sheet and financial

disclosures and to explore how this information is used by decision makers.

Learning Objectives

LO3–1 Describe the purpose of the balance sheet and understand its usefulness and limitations.

LO3–2 Identify and describe the various balance sheet asset classifications.

LO3–3 Identify and describe the various liability and shareholders’ equity classifications.

LO3–4 Explain the purpose of financial statement disclosures.

LO3–5 Describe disclosures related to management’s discussion and analysis, responsibilities, and

compensation.

LO3–6 Explain the purpose of an audit and describe the content of the audit report.

LO3–7 Describe the techniques used by financial analysts to transform financial information into

forms more useful for analysis.

LO3–8 Identify and calculate the common liquidity and solvency ratios used to assess risk.

LO3–9 Discuss the primary differences between U.S. GAAP and IFRS with respect to the balance

sheet, financial disclosures, and segment reporting.

Lecture Outline

Part A: The Balance Sheet

I. Usefulness

A. The balance sheet, sometimes referred to as the statement of financial position, provides

information useful for assessing future cash flows, liquidity, and long-term solvency.

II. Limitations

A. Assets minus liabilities, measured according to GAAP, is not likely to be representative of

the market value of the entity (number of common stock shares outstanding multiplied by

price per share).

III. Classification of Elements

A. Assets are probable future economic benefits obtained or controlled by a particular entity

as a result of past transactions or events. Simply, these are the economic resources of a

company.

1. Current assets include cash and all other assets expected to become cash or be

consumed within one year or the operating cycle, whichever is longer.

a. Cash and cash equivalents

b. Short-term investments

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c. Accounts receivable

d. Inventories

e. Prepaid expenses

2. Long-term (or noncurrent) assets are those assets that are expected to provide benefits

beyond the next year (or operating cycle).

a. Investments

b. Property, plant, and equipment

c. Intangible assets

d. Other long-term assets

B. Liabilities are 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. Simply, these are the obligations of a

company.

1. Current liabilities, in general, are expected to be satisfied within one year or the

operating cycle, whichever is longer.

a. Accounts payable

b. Notes payable

c. Deferred revenues

d. Accrued liabilities

e. Current maturities of long-term debt

2. Long-term liabilities are obligations that will not be satisfied in the next year or

operating cycle, whichever is longer.

C. Shareholders’ equity is the residual interest in the assets of an entity that remains after

deducting liabilities. Stated another way, stockholders’ equity equals total assets minus

total liabilities. The two primary components of equity include paid-in capital and retained

earnings.

1. Paid-in capital represents the amounts invested by shareholders.

2. Retained earnings represents the accumulated net income reported since the inception

of the company and not yet paid to shareholders.

Shareholders’ equity also includes:

3. Accumulated other comprehensive income (loss). This represents changes in equity

(other than transactions with owners, such as issuing shares and paying dividends) not

reported in net income.

4. Treasury stock. This represents a company’s purchase (but not retirement) of its own

stock.

D. There are more similarities than differences in balance sheets prepared according to U.S.

GAAP and those prepared applying IFRS.

Part B: Financial Disclosures

I. Disclosure Notes

A. Disclosure notes include certain required notes as well as notes fashioned to suit the

disclosure needs of the reporting enterprise.

B. The summary of significant accounting policies conveys valuable information about the

company’s choices from among various alternative accounting methods.

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C. A subsequent event is a significant development that takes place after the company’s fiscal

year-end but before the financial statements are issued.

D. Related-party transactions are those between the company and owners, management,

families of owners or management, affiliated companies, and other parties that can

significantly influence or be influenced by the company. The economic substance of

related-party transactions should be disclosed, including dollar amounts involved.

II. Management’s Discussion and Analysis

The management’s discussion and analysis provides a biased but informed perspective of a

company’s (a) operations, (b) liquidity, and (c) capital resources.

III. Management’s Responsibilities

Annual reports include a management’s responsibility section that asserts the responsibility of

management for the information contained in the annual report as well as an assessment of the

company’s internal control procedures.

IV. Compensation of Directors and Top Executives

A. The proxy statement, which must be provided each year to all shareholders, serves as an

invitation to attend the company’s annual meeting and as a means to vote on issues before

the shareholders.

B. The proxy statement also contains disclosures on compensation to directors and

executives.

V. Auditors’ Report

A. The auditors’ report provides an independent and professional opinion about the fairness of

the representations in the financial statements and about the effectiveness of the

company’s internal control over financial reporting.

B. The four basic types of auditors’ reports are:

1. Unqualified (or “clean”)

2. Unqualified with an explanatory paragraph (lack of consistency, going concern, or

emphasis of matter)

3. Qualified (scope limitation or departure from GAAP)

4. Adverse (serious misstatement) or disclaimer (severe scope limitation)

Part C: Risk Analysis

I. Using Financial Statement Information

A. Financial analysts use various techniques when analyzing financial statement information.

1. Comparative financial statements—compare year-to-year financial position, results of

operations, and cash flows.

2. Horizontal analysis—percentage change in financial statement item since a base year.

3. Vertical analysis—financial statement item expressed as a percentage of a total

amount.

4. Ratio analysis—convert financial statement items to ratios.

B. The most common way of comparing accounting numbers to evaluate the performance

and risk of a firm is ratio analysis.

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II. Liquidity Ratios

A. Liquidity refers to the ability of a company to convert its assets to cash to pay its current

obligations.

B. Working capital, the difference between current assets and current liabilities, is a popular

measure of a company’s ability to satisfy its short-term obligations.

C. The current ratio, calculated by dividing current assets by current liabilities, expresses

working capital as a ratio that allows for interfirm comparisons.

D. The acid-test ratio provides a more stringent indication of a company’s ability to pay its

current obligations. The ratio excludes inventories and prepaid expenses from current

assets before dividing by current liabilities.

III. Solvency Ratios

A. Solvency ratios provide some indication of the riskiness of a company with regard to its

ability to pay its long-term debts.

B. The debt to equity ratio indicates the extent of reliance on creditors, rather than owners, in

providing resources.

1. The ratio is calculated by dividing total liabilities by total shareholders’ equity.

2. The debt to equity ratio indicates the extent of trading on the equity or financial

leverage.

C. The times interest earned ratio indicates the margin of safety provided to creditors. It is

calculated by dividing income before subtracting either interest expense or taxes by

interest expense.

D. Favorable financial leverage means earning a return on borrowed funds that exceeds the

cost of borrowing the funds.

Appendix 3: Reporting Segment Information

A. Segment reporting facilitates the financial statement analysis of diversified companies.

B. Information is reportable for identifiable operating segments.

C. Only segments of a certain size (10% or more of total company revenues, assets, or net

income) must be disclosed. However, a company must account for at least 75% of

consolidated revenue through segment disclosures.

D. For areas determined to be reportable operating segments, the following disclosures are

required:

1. General information about the operating segment.

2. Information about reported segment profit or loss, including certain revenues and

expenses included in reported segment profit or loss, segments assets, and the basis of

measurement.

3. Reconciliations of the totals of segments revenues, reported profit or loss, assets, and

other significant items to corresponding enterprise amounts.

4. Interim period information.

E. GAAP requires an enterprise to report certain geographic information unless it is

impracticable to do so.

F. Revenues from major customers must be disclosed.

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PowerPoint Slides

Three PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the chapter, but

they can be easily edited to allow instructors to change numbers and content in

illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

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Suggestions for Class Activities

1. Research Activity

The balance sheet does not portray the market value of the entity. A company’s book value

(shareholders’ equity) will likely be less than its market value as measured by the market value of its

shares outstanding (number of common stock shares outstanding multiplied by price per share).

Market value often is referred to as the company’s “market capitalization.”

Suggestions:

Have the class obtain and compare the book value and market value for a number of large

companies. Ask them to think of reasons why the ratios of market to book differ across their sample

of firms. EDGAR (www.sec.gov) is an efficient Internet site for them to obtain book values, and

market values can be obtained many places. For example, Yahoo Finance (finance.yahoo.com)

provides the company’s market capitalization.

2. Research Activity

The ratio of market value to book value for most oil and gas companies is significantly greater than

1.0.

Suggestions:

Have the class consider why an oil and gas company would have a ratio greater than 1.0. One

reason is that these companies have proven oil and gas reserves listed in their balance sheets that are

worth more than their book values. GAAP requires that these companies provide information about

proven oil and gas reserves. Specifically, they must provide supplemental market information called

the standardized measure. This measure is equal to the net present value of the after-tax cash flows

associated with the future sales of oil and gas. Have them access the Internet to determine the

market-to-book ratio for Chevron. Ask them to find the value of proven oil and gas reserves reported

in the supplemental disclosure and compare that to the book value of those assets.

3. Target Analysis

Have students, individually or in groups, go to the most recent Target Corporation annual report

using EDGAR at: www.sec.gov. Ask them to:

1. Compare the balance sheet with that presented in the 2016 report in Appendix B of the text.

Are there any differences in the classifications used or the elements contained in those

classifications?

2. Compare the Summary of Significant Accounting Policies disclosure note with that presented

in the 2016 report. Have there been any discernible changes in accounting policies employed

by the company?

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3. Compute the financing ratios discussed in the chapter for the most recent annual report year

and for the 2016 year and compare their results. Are there any discernible trends? How might

they be interpreted?

4. Determine if the company reported any subsequent events in the disclosure notes.

5. Use EDGAR to locate the most recent annual report information for PetMed Express, a pet

pharmacy company. Using the most recent annual report information for both companies,

compare financing ratios discussed in the chapter. Also, are there any accounting policy

differences that could have an impact on the comparison of the two companies?

4. Professional Skills Development Activities

The following are suggested assignments from the end-of-chapter material that will help your

students develop their communication, research, analysis, and judgment skills.

Communication Skills. In addition to Communication Case 3–1, Judgment Case 3–11 can be

adapted to ask students to write a letter to a client explaining the effects of the two financing

alternatives. Communication Case 3–3 and Judgment Case 3–5 do well as group assignments.

These two cases, along with Problem 3–7 create good class discussions. Analysis Cases 3–12

and 3–13, along with Research Case 3–9, are suitable for student presentation(s).

Research Skills. In their careers, our graduates will be required to locate and extract relevant

information from available resource material to determine the correct accounting practice,

perhaps identifying the appropriate authoritative literature to support a decision. Research Case

3–9 and Exercises 3–13 and 3–14 provide excellent opportunities to help students develop this

skill. In addition, Real World Case 3–10 can be adapted to require students to research the

authoritative literature on the required disclosures for subsequent events.

Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct

students to gather, assemble, organize, process, or interpret data to provide options for making

business and investment decisions. In addition to Analysis Cases 3–2, 3–12, 3–13, and 3–14;

and Exercises 3–16, 3–17, 3–18, and 3–19; Real World Case 3–7 and Judgment Case 3–11 also

provide opportunities to develop and sharpen analytical skills.

Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require

students to critically analyze issues to apply concepts learned to business situations in order to

evaluate options for decision making and provide an appropriate conclusion. In addition to

Judgment Cases 3–5, 3–6, 3–8, and 3–11, Analysis Cases 3–12 and 3–13 also require students

to exercise judgment.

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