Week 1

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Chapter 3

Balance Sheet

Also called as statement of financial position and statement of financial condition

Shows financial condition as of a specific date

The accounting equation expresses the relationship among elements of balance sheet

Assets = Liabilities + Stockholders’ Equity

Format

Account form (side by side)

Report form (assets at top and liabilities and stockholders’ equity at bottom) dominant in the U.S.

Balance Sheet

Exhibit 3-1—Quaker Chemical Corporation

Probable future economic benefits obtained or controlled by an entity as a result of past transactions or events

May be physical or intangible

Major categories

Current Assets

Includes cash, and assets that will be realized in cash during the operating cycle or one year which ever is longer

Noncurrent or Long-term Assets

Includes assets that take longer than one year or operating cycle to convert or to conserve cash

Assets

Cash and assets that will be converted into cash during the operating cycle or within a year, whichever is longer

Presented in order of liquidity

Cash

Includes negotiable checks, unrestricted balance in checking accounts, cash on hand, savings accounts

Current Assets

Marketable Securities—readily determinable market price

Debt or equity securities

Carried at fair value

To be converted into cash during the current period

Accounts Receivable

Amounts due from sales or services rendered

Carried at net realizable value (net of allowances)

All allowances are carried in one allowance account

Other receivables due from nontrade sources

Current Assets—Continued

Inventories

Balance of goods on hand

Categories

Merchandise on hand—retail or wholesale firms

Raw materials

Work in process

Finished goods

Carried at the lower of cost or market

Supplies could include register tapes, pencils, or sewing machine needles for the shirt factory

Current Assets—Continued

Manufacturer

Prepaids

Expenditures made in advance of the use of the service or goods

Represent future benefits resulting from past transactions

Examples

Insurance

Advertising

Taxes

Promotion costs

Early payments on long-term contracts

Current Assets—Continued

Land

Carried at acquisition cost

Not subject to depreciation

Natural resources are depleted

Buildings

Presented at cost plus permanent improvements

Depreciated over their estimated useful life

Long-Term Assets: Tangible

Machinery

Historical cost, including costs of delivery, installation, and material improvements

Depreciated over its useful life

Construction in Progress

Assets under construction

Costs will be transferred to permanent asset account upon completion

Long-Term Assets: Tangible—Continued

Accumulated Depreciation

Carries the to-date depreciation of plant assets

It is subtracted from the cost of the asset to determine the book value

Factors used in depreciation calculation

Asset cost

Length of the life of the asset

Estimated salvage (residual) value of asset when retired

Long-Term Assets: Tangible—Continued

Depreciation Methods

Straight-line

Declining-balance

Sum-of-the-years’-digits

Units-of-production

Balance Sheet Presentation

Long-Term Assets: Tangible—Continued

Cost of the asset

Less: Accumulated depreciation

Net book value

Cost of asset $10,000

Estimated salvage $ 2,000

Estimated life 5 years

Depreciation: Straight-Line Method

The salvage value is not depreciated and it equals book value at end of useful life

Depreciation: Straight-Line Method —Continued

Year	Depreciation for Year	Accumulated Depreciation at End of Year	Cost	Book Amount at End of Year
1	$1,600	$1,600	$10,000	$8,400
2	1,600	3,200	10,000	6,800
3	1,600	4,800	10,000	5,200
4	1,600	6,400	10,000	3,600
5	1,600	8,000	10,000	2,000

Cost $10,000

Estimated salvage $ 2,000

Estimated life 5 years

Depreciation: Declining-Balance Method

Salvage value is not used in the depreciation formula but depreciation ends when the book value equals the salvage value

Depreciation: Declining-Balance Method—Continued

Year	Cost	Accumulated Depreciation at Beg. of Year	Book Amount at Beginning of Year	Depreciation for Year	Book Amount at End of Year
1	$10,000	—	$10,000	$4,000	$6,000
2	10,000	$4,000	6,000	2,400	3,600
3	10,000	6,400	3,600	1,440	2,160
4	10,000	7,840	2,160	160	2,000
5	10,000	8,000	2,000	—	2,000

Cost $10,000

Estimated salvage $ 2,000

Estimated life 5 years

Depreciation: Sum-of-the-Years’-Digits Method

Depreciation: Sum-of-the-Years’-Digits Method—Continued

Year	Cost Less Salvage Value	Fraction	Depreciation for Year	Accumulated Depreciation at End of Year	Book Amount at End of Year
1	$8,000	5/15	$2,666.67	$2,666.67	$7,333.33
2	8,000	4/15	2,133.33	4,800.00	5,200.00
3	8,000	3/15	1,600.00	6,400.00	3,600.00
4	8,000	2/15	1,066.67	7,466.67	2,533.33
5	8,000	1/15	533.33	8,000.00	2,000.00

Cost $10,000

Estimated salvage $ 2,000

Estimated total hours 16,000

Actual hours of operation 2,000

Depreciation: Units-of-Production Method

Actual Hours of Operation × Rate = Depreciation

2,000 hours × $0.50 = $1,000

Therefore, the depreciation expense for year one is $1,000

Asset is depreciated until book value equals salvage value

Depreciation: Units-of-Production Method—Continued

Capital Lease

It is in-substance an ownership arrangement

Classified as long term asset; shown net of amortization

Long-Term Assets: Leases

Debt or Equity Securities

Held to maintain business relationship or to exercise control

Debt Securities Classification

Held-to-maturity securities are carried at amortized cost

Available-for-sale securities are carried at fair value

Long-Term Assets: Investments

Equity Securities

Carried at fair value which have 3 levels for input

Level 1: Quoted price for identical item in active market

Level 2: Adjusted quoted price of similar asset (or liability)

Level 3: Present value of expected cash flows

Exception- Equity method is used where there is significant influence

Cost is adjusted for the proportionate share of the rise/fall in the retained profits of the subsidiary (investee)

Long-Term Assets: Investments—Continued

Intangibles are nonphysical assets

They are recorded at historical cost

An intangible asset that has a finite life is amortized over its useful life

An intangible asset with an indefinite life are reviewed for impairment

Long-Term Assets: Intangibles

Goodwill

Arises form the acquisition of a business where price paid exceeds the fair value of net assets

According to U.S. GAAP it is not amortized but tested annually for impairment

Patents

Exclusive legal rights granted to an inventor for a period of 20 years

Valued at their acquisition cost

Amortized over shorter of legal or useful life

Long-Term Assets: Intangibles—Continued

Trademarks

Distinctive names or symbols

Indefinite legal life

Not amortized but tested for impairment annually

Franchises

Legal right to operate under a particular corporate name, providing trade-name products or services

Amortize over the life of the franchise

Long-Term Assets: Intangibles—Continued

Copyrights

Rights that authors, painters, musicians, sculptors, and other artists have in their creations and expressions

It is granted for life of the creator, plus 70 years

Amortize over the period of expected benefit

Long-Term Assets: Intangibles—Continued

Few assets do not fit into any of the previously discussed classification

Include noncurrent receivables and noncurrent prepaids

Other Noncurrent Assets

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

Current Liabilities

Long-term Liabilities

Liabilities

Obligations whose liquidation is reasonably expected within one year or the operating cycle, whichever is longer

Require

Use of existing current assets

Creation of other current liabilities

Current Liabilities

Payables

Short-term obligations created by the acquisition of goods or services

Unearned Income

Payments collected in advance of the performance of services or delivery of goods

Other Current Liabilities

Current Liabilities—Continued

Due in a period beyond one year or operating cycle, whichever is longer

Types

Financing arrangements of assets

Operational obligations

Long-Term Liabilities

Notes Payable

Promissory notes

If secured by property, they are called mortgage notes

Credit Agreements

Ready lines of credit that may require a compensating balance

In return for giving a credit agreement, the bank or insurance company obtains a fee

Not a liability until funds are drawn

Liabilities Relating to Financing Agreements

Bonds Payable

Sold at par, premium, or discount

Premium or discount is amortized into interest expense

Bond carrying value is amortized to par value

Convertible bonds can be converted into common stock

Conversion feature enhances the bond’s selling price

Liabilities Relating to Financing Agreements—Continued

Exhibit 3-13—Bonds at Par, Premium, or Discount

Deferred Taxes

Caused by using different accounting methods for tax and reporting purposes

It causes tax expense for reporting purposes to be higher than taxes payable according to the tax return

The difference is deferred tax

Warranty Obligations

Estimated obligations arising out of product warranties

Estimated to recognize the obligation at the balance sheet date and to charge expense

Liabilities Relating to Operational Obligations

Noncontrolling Interest

Previously called “minority interest”

Reflects the ownership of noncontrolling shareholders in the equity of consolidated subsidiaries less than wholly owned

Reported on consolidated financial statements as equity, but separate from parents equity

If material, analysis can be performed twice

Once as a liability to be conservative and then as shareholders’ equity item

Liabilities Relating to Operational Obligations—Continued

Other Noncurrent Liabilities

Redeemable Preferred Stock

Excluded from stockholders’ equity

For analysis, treated as a liability

Liabilities Relating to Operational Obligations—Continued

Also called shareholders’ equity

The residual ownership interest in the assets of an entity that remains after deducting its liabilities

Paid-in capital

Retained earnings

Stockholders’ Equity

Two basic types of capital stock

Preferred

Common

Par value

In some states, referred to as “stated value stock”

Considered “legal capital” by many states

Established by the articles of incorporation

Usually a minimal value

Some states allow the issuance of no-par stock

Stockholders’ Equity: Paid-In Capital

Additional Paid-In Capital

Issue price in excess of par (stated) value

Other sources

Treasury stock transactions

Stock dividend transactions

Donated capital

Stockholders’ Equity: Paid-in Capital—Continued

Shareholder ownership

Voting rights

Election of board of directors

Major corporate decisions

Liquidation rights secondary to

Creditors

Preferred stockholders’

Stockholders’ Equity: Common Stock

Does not normally convey voting rights

May carry any or all of these features:

Preference as to dividends

Accumulation of dividends

Participation in excess of stated dividend rate

Convertibility into common stock at holder’s discretion

Callability by the corporation

Redemption at future maturity date

Preference in liquidation secondary to creditors

Stockholders’ Equity: Preferred Stock

May be included in the paid-in capital

Donated by outside entities

Example: Shareholder surrender of stock

Stockholders’ Equity: Donated Capital

Undistributed earnings of the corporation

Net income for all prior periods

Less dividends (both cash and stock) declared to shareholders

Stockholders’ Equity: Retained Earnings

Quasi-Reorganization

Eliminates a deficit balance of retained earnings and an equal amount from paid-in-capital

Retained earnings dated as of the readjustment date and disclosed in the financial statements for a period of five to ten years

Accumulated Other Comprehensive Income

Represents retained earnings from other comprehensive income

Disclosed as a separate component on the face of the balance sheet or in the notes

Stockholders’ Equity: Others

Employee Stock Ownership Plans (ESOPs)

A qualified stock-bonus plan, or a combination of stock-bonus and money-purchase pension plan

Tax benefits for the employer and employee

Unearned compensation decreases stockholders’ equity

Stockholders’ Equity: Others—Continued

Treasury Stock

Stock purchased and held by the issuing corporation

Record treasury stocks in two ways

Par-value method

Removes the paid-in capital in excess of par from the original issue

Appears as a reduction of paid-in capital

Cost method

Records treasury stock at the cost of the stock (presented as a reduction of stockholders’ equity)

Most firms record treasury stock at cost

Stockholders’ Equity: Others—Continued

Reconciles the beginning and ending balances of stockholders’ equity accounts

Changes in stockholders’ equity accounts

Issuance of stock increases paid-in capital

Acquisition of treasury stock increases treasury stock

Net income increases retained earnings

Dividends decreases retained earnings

This account is related to comprehensive income

Statement of Stockholders’ Equity

Financial analysis is complicated by

Many assets recorded at cost rather than fair (replacement) value

Varying valuation methods

Within a firm from product to product

Within an industry from firm to firm

Not all items of value are listed as assets

Certain contingent liabilities may be excluded

Problems in Balance Sheet Presentation

Asset section

Usually noncurrent assets are presented first, followed by current assets

Liabilities and Owner’s Equity section

“Capital and reserves” are usually listed first, then noncurrent liabilities, and at last, current liabilities

The reserves sections of “capital and reserves” would not be part of U.S. GAAP

International Consolidated Balance Sheet (IFRS)

Occur during the period between the balance sheet date and the date statements are issued

Types

Events requiring retroactive recognition

Relates to estimates that were made and subsequent events indicates estimates were incorrect

Events requiring disclosure in the notes to the financial statements

Does not affect the balance sheet, but is significant to the users of the financial statement

Subsequent Events

Cost Salvage Value

= Annual Depreciation

Estimated Value

$10,000 $2,000

$1,600

5 Years

× 2 = Double the straight-line rate

Estimated Life

× 2 × Book Value at Beginning of Ye

ar = Annual Depreciation

*Double the straight-line rate is the ma

ximum rate

Number of Remaining Years

(Cost Salvage) = Annual Depreciation

Sum of Digits of Estimated Life

($10,000$2,000) $2,666.67

(54321) or 15

´-

´-=

++++

Cost Salvage Value

Per Unit Depreciation

Estimated Life in Capacity

10,0002,000

= $0.50

16,000 Hours