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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.
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 two balance sheet liability classifications.
LO3-4 Explain the purpose of financial statement disclosures.
LO3-5 Explain the purpose of the management discussion and analysis disclosure.
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 financing 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 and Limitations
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. Classification of Elements (T3-1)
A. Assets are probable future economic benefits obtained or controlled by a particular entity
as a result of past transactions or events. 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. (T3-2) (T3-3)
a. Cash and cash equivalents
3-2 Intermediate Accounting, 8/e
2. Noncurrent (or long-term) assets are those assets that are expected to provide benefits
beyond the next year (or operating cycle). (T3-4)
a. Investments
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. 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. (T3-5)
a. Accounts payable
2. Long-term liabilities are obligations that will not be satisfied in the next year or
operating cycle, whichever is longer. (T3-6)
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 components of equity include paid-in capital and retained
earnings. (T3-7)
1. Paid-in capital represents the amounts invested by shareholders.
Part B: Financial Disclosures
I. Disclosure Notes (T3-8)
A. Disclosure notes include certain required notes as well as notes fashioned to suit the
disclosure needs of the reporting enterprise.
II. Management Discussion and Analysis (T3-8)
III. Management's Responsibilities (T3-8)
Annual reports include a management's responsibility section which:
1. Asserts the responsibility of management for the information contained in the annual
IV. Auditors' Report (T3-8)
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 standard report includes four paragraphs.
1. The first two paragraphs describe the scope of the audit.
3. The last paragraph provides the auditors’ opinion on the effectiveness of the
company’s internal control over financial reporting.
C. Some audits result in the need to issue other than an unqualified opinion.
1. Qualified opinion
3. Disclaimer
V. Compensation of Directors and Top Executives (T3-8)
A. The proxy statement, which must be sent 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.
Part C: Risk Analysis
I. Using Financial Statement Information
A. Financial analysts use various techniques when analyzing financial statement information.
B. Comparative financial statements allow financial statement users to compare year-to-year
financial position, results of operations, and cash flows.
1. Horizontal analysis
2. Vertical analysis
C. The most common way of comparing accounting numbers to evaluate the performance
and risk of a firm is ratio analysis.
II. Liquidity Ratios (T3-9)
A. Liquidity refers to the readiness of assets to be converted to cash.
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.
3-4 Intermediate Accounting, 8/e
III. Financing Ratios (T3-10)
A. Financing 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.
2. The debt to equity ratio indicates the extent of trading on the equity or financial
leverage.
3. Favorable financial leverage means earning a return on borrowed funds that exceeds
the cost of borrowing the funds.
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.
Appendix 3: Reporting Segment Information (T3-11)
A. Segment reporting facilitates the financial analysis of diversified companies.
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 operating segments, the following disclosures are required:
2. Information about reported segment profit or loss, including certain revenues and
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.
PowerPoint Slides
A PowerPoint presentation of the chapter is available in the Connect
library.
Teaching Transparency Masters
The following can be reproduced on transparency film as they appear
3-6 Intermediate Accounting, 8/e
BALANCE SHEET CLASSIFICATIONS
Assets
=
Liabilities
+
Shareholders’
Equity
2. Long-term assets:
2. Long-term liabilities
2. Retained earnings
• Investments
T3-1
OPERATING CYCLE
➢ The operating cycle for a typical manufacturing company
refers to the period of time necessary to convert cash to raw
materials, raw materials to a finished product, the finished
product to receivables, and then finally receivables back to
cash.
①
Use cash
to acquire raw
materials
Illustration 3-2
T3-2
3-8 Intermediate Accounting, 8/e
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.
Cash and Cash Equivalents
Cash includes:
▶ Bank drafts
▶ Cashier’s checks
▶ Money orders
Cash Equivalents include liquid investments that have a maturity date of three
months or less from the date of purchase, such as:
▶ Commercial paper
▶ Money market funds
▶ U.S. Treasury bills
Short-term Investments
Investments are classified as current if the company’s management
▶ intends to liquidate the investment in the next year or operating cycle,
Accounts Receivable
▶ Arise from the sale of goods or services on credit.
▶ Are valued net of allowance for uncollectible accounts.
Inventories
▶ Inventories consist of assets that a retail or wholesale company acquires
for resale or goods that manufacturers produce for sale.
Prepaid Expenses
▶ Arise when a cash payment creates benefits beyond the current period.
▶ Examples are prepaid rent and prepaid insurance.
NONCURRENT ASSETS
Investments
➢ Assets not used directly in the operations of the business.
➢ Examples include:
▶ Investments in equity and debt securities of other corporations
▶ Land held for speculation
Property, Plant, and Equipment
➢ Tangible, long-lived assets used in the operations of the business.
➢ They are usually the primary revenue-generating assets of the business.
➢ Examples include:
Intangible Assets
➢ They lack physical existence.
➢ Exclusive rights to something — a product, process, etc.
➢ Examples include:
▶ Patents
Other Assets
➢ A catch-all classification that includes long-term prepaid expenses, called
deferred charges, and any noncurrent asset not falling in one of the other
classifications.
T3-4
3-10 Intermediate Accounting, 8/e
CURRENT LIABILITIES
Current liabilities are those obligations that are expected to be
satisfied within one year or the operating cycle, whichever is
longer.
Accounts Payable
➢ Obligations to suppliers of merchandise or services purchased on open
account.
➢ Payment usually is due in 30 to 60 days.
Notes Payable
➢ Written promises to pay cash at some future date.
➢ Usually require the payment of explicit interest.
Deferred Revenues
➢ Represent cash received from a customer for goods or services to be
provided in a future period.
Accrued Liabilities
➢ Obligations created when expenses have been incurred but won't be paid
until a subsequent reporting period.
➢ Examples include:
▶ Accrued salaries payable
Current Maturities of Long-term Debt
T3-5
LONG-TERM LIABILITIES
Long-term liabilities are those obligations that are not
expected to be satisfied within one year or the operating
cycle, whichever is longer.
Examples include:
▶ Long-term notes
T3-6
3-12 Intermediate Accounting, 8/e
SHAREHOLDERS' EQUITY
Shareholders' equity is comprised of paid-in capital (invested
capital) and retained earnings (earned capital).
Paid-in capital
➢ Amounts invested by shareholders.
Retained earnings
FINANCIAL DISCLOSURES
Summary of Significant Accounting Policies
➢ A summary of the company's significant accounting
policies is a required disclosure. Examples include
Subsequent events
➢ A subsequent event is a significant occurrence between the
date of the financial statements and the date the statements
are issued or available to be issued.
Related-party transactions
Management discussion and analysis
➢ The management discussion and analysis provides a biased
but informed perspective of
T3-8
