CHAPTER 5 Balance Sheet and Statement of Cash Flows

BALANCE SHEET

The balance sheet, sometimes referred to as the statement of financial position, reports the assets, liabilities, and stockholders' equity of a business enterprise at a specific date. This financial statement provides information about the nature and amounts of investments in enterprise resources, obligations to creditors, and the owners' equity in net resources. It therefore helps in predicting the amounts, timing, and uncertainty of future cash flows.

Usefulness of the Balance Sheet

By providing information on assets, liabilities, and stockholders' equity, the balance sheet provides a basis for computing rates of return and evaluating the capital structure of the enterprise. Analysts also use information in the balance sheet to assess a company's risk¹ and future cash flows. In this regard, analysts use the balance sheet to assess a company's liquidity, solvency, and financial flexibility.

Liquidity describes “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.”² Creditors are interested in short-term liquidity ratios, such as the ratio of cash (or near cash) to short-term liabilities. These ratios indicate whether a company, like Amazon.com, will have the resources to pay its current and maturing obligations. Similarly, stockholders assess liquidity to evaluate the possibility of future cash dividends or the buyback of shares. In general, the greater Amazon's liquidity, the lower its risk of failure.

Solvency refers to the ability of a company to pay its debts as they mature. For example, when a company carries a high level of long-term debt relative to assets, it has lower solvency than a similar company with a low level of long-term debt. Companies with higher debt are relatively more risky because they will need more of their assets to meet their fixed obligations (interest and principal payments).

Liquidity and solvency affect a company's financial flexibility, which measures the “ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.”³ For example, a company may become so loaded with debt—so financially inflexible—that it has little or no sources of cash to finance expansion or to pay off maturing debt. A company with a high degree of financial flexibility is better able to survive bad times, to recover from unexpected setbacks, and to take advantage of profitable and unexpected investment opportunities. Generally, the greater an enterprise's financial flexibility, the lower its risk of failure.

Limitations of the Balance Sheet

Some of the major limitations of the balance sheet are:

1. Most assets and liabilities are reported at historical cost. As a result, the information provided in the balance sheet is often criticized for not reporting a more relevant fair value. For example, Georgia-Pacific owns timber and other assets that may appreciate in value after purchase. Yet, Georgia-Pacific reports any increase only if and when it sells the assets.
2. Companies use judgments and estimates to determine many of the items reported in the balance sheet. For example, in its balance sheet, Dell estimates the amount of receivables that it will collect, the useful life of its warehouses, and the number of computers that will be returned under warranty.

   

3. The balance sheet necessarily omits many items that are of financial value but that a company cannot record objectively. For example, the knowledge and skill of Intel employees in developing new computer chips are arguably the company's most significant assets. However, because Intel cannot reliably measure the value of its employees and other intangible assets (such as customer base, research superiority, and reputation), it does not recognize these items in the balance sheet. Similarly, many liabilities are reported in an “off-balance-sheet” manner, if at all.

The bankruptcy of Enron, the seventh-largest U.S. company at the time, highlights the omission of important items in the balance sheet. In Enron's case, it failed to disclose certain off-balance-sheet financing obligations in its main financial statements.⁴

Classification in the Balance Sheet

Balance sheet accounts are classified. That is, balance sheets group together similar items to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown.

The FASB has often noted that the parts and subsections of financial statements can be more informative than the whole. Therefore, the FASB discourages the reporting of summary accounts alone (total assets, net assets, total liabilities, etc.). Instead, companies should report and classify individual items in sufficient detail to permit users to assess the amounts, timing, and uncertainty of future cash flows. Such classification also makes it easier for users to evaluate the company's liquidity, financial flexibility, profitability, and risk.

To classify items in financial statements, companies group those items with similar characteristics and separate items with different characteristics.⁵ For example, companies should report separately:

1. Assets that differ in their type or expected function in the company's central operations or other activities. For example, IBM reports merchandise inventories separately from property, plant, and equipment.
2. Assets and liabilities with different implications for the company's financial flexibility. For example, a company that uses assets in its operations, like Walgreens, should report those assets separately from assets held for investment and assets subject to restrictions, such as leased equipment.
3. Assets and liabilities with different general liquidity characteristics. For example, Boeing Company reports cash separately from inventories.

The three general classes of items included in the balance sheet are assets, liabilities, and equity. We defined them in Chapter 2 as follows.

Companies then further divide these items into several subclassifications. Illustration 5-1 indicates the general format of balance sheet presentation.

A company may classify the balance sheet in some other manner, but in practice you usually see little departure from these major subdivisions. A proprietorship or partnership does present the classifications within the owners' equity section a little differently, as we will show later in the chapter.

Current Assets

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. The operating cycle is the average time between when a company acquires materials and supplies and when it receives cash for sales of the product (for which it acquired the materials and supplies). The cycle operates from cash through inventory, production, receivables, and back to cash. When several operating cycles occur within one year (which is generally the case for service companies), a company uses the one-year period. If the operating cycle is more than one year, a company uses the longer period.

Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current assets section, and their bases of valuation, are shown in Illustration 5-2.

A company does not report these five items as current assets if it does not expect to realize them in one year or in the operating cycle, whichever is longer. For example, a company excludes from the current assets section cash restricted for purposes other than payment of current obligations or for use in current operations. Generally, if a company expects to convert an asset into cash or to use it to pay a current liability within a year or the operating cycle, whichever is longer, it classifies the asset as current.

This rule, however, is subject to interpretation. A company classifies an investment in common stock as either a current asset or a noncurrent asset depending on management's intent. When it has small holdings of common stocks or bonds that it will hold long-term, it should not classify them as current.

Although a current asset is well defined, certain theoretical problems also develop. For example, how is including prepaid expenses in the current assets section justified? The rationale is that if a company did not pay these items in advance, it would instead need to use other current assets during the operating cycle. If we follow this logic to its ultimate conclusion, however, any asset previously purchased saves the use of current assets during the operating cycle and would be considered current.

Another problem occurs in the current-asset definition when a company consumes plant assets during the operating cycle. Conceptually, it seems that a company should place in the current assets section an amount equal to the current depreciation charge on the plant assets, because it will consume them in the next operating cycle. However, this conceptual problem is ignored. This example illustrates that the formal distinction made between some current and noncurrent assets is somewhat arbitrary.

Cash. Cash is generally considered to consist of currency and demand deposits (monies available on demand at a financial institution). Cash equivalents are short-term highly liquid investments that will mature within three months or less. Most companies use the caption “Cash and cash equivalents,” and they indicate that this amount approximates fair value.

A company must disclose any restrictions or commitments related to the availability of cash. As an example, see the excerpt from the annual report of Alterra Healthcare Corp. in Illustration 5-3 (page 218).

Alterra Healthcare restricted cash to meet an obligation due currently. Therefore, Alterra included this restricted cash under current assets.

If a company restricts cash for purposes other than current obligations, it excludes the cash from current assets. Illustration 5-4 shows an example of this, from the annual report of Owens Corning, Inc.

Short-Term Investments. Companies group investments in debt and equity securities into three separate portfolios for valuation and reporting purposes:

A company should report trading securities (whether debt or equity) as current assets. It classifies individual held-to-maturity and available-for-sale securities as current or noncurrent depending on the circumstances. It should report held-to-maturity securities at amortized cost. All trading and available-for-sale securities are reported at fair value. [1]⁷

For example, Illustration 5-5 is an excerpt from the annual report of Intuit Inc. with respect to its available-for-sale investments.

Receivables. A company should clearly identify any anticipated loss due to uncollectibles, the amount and nature of any nontrade receivables, and any receivables used as collateral. Major categories of receivables should be shown in the balance sheet or the related notes. For receivables arising from unusual transactions (such as sale of property, or a loan to affiliates or employees), companies should separately classify these as long-term, unless collection is expected within one year. Stanley Black & Decker reported its receivables as shown in Illustration 5-6.

Inventories. To present inventories properly, a company discloses the basis of valuation (e.g., lower-of-cost-or-market) and the cost flow assumption used (e.g., FIFO or LIFO). A manufacturing concern (like Abbott Laboratories, shown in Illustration 5-7 on page 220) also indicates the stage of completion of the inventories.

Weyerhaeuser Company, a forestry company and lumber manufacturer with several finished-goods product lines, reported its inventory as shown in Illustration 5-8.

Prepaid Expenses. A company includes prepaid expenses in current assets if it will receive benefits (usually services) within one year or the operating cycle, whichever is longer. As we discussed earlier, these items are current assets because if they had not already been paid, they would require the use of cash during the next year or the operating cycle. A company reports prepaid expenses at the amount of the unexpired or unconsumed cost.

A common example is the prepayment for an insurance policy. A company classifies it as a prepaid expense because the payment precedes the receipt of the benefit of coverage. Other common prepaid expenses include prepaid rent, advertising, taxes, and office or operating supplies. Hasbro, Inc., for example, listed its prepaid expenses in current assets as shown in Illustration 5-9.

Noncurrent Assets

Noncurrent assets are those not meeting the definition of current assets. They include a variety of items, as we discuss in the following sections.

Long-Term Investments. Long-term investments, often referred to simply as investments, normally consist of one of four types:

1. Investments in securities, such as bonds, common stock, or long-term notes.
2. Investments in tangible fixed assets not currently used in operations, such as land held for speculation.
3. Investments set aside in special funds, such as a sinking fund, pension fund, or plant expansion fund. This includes the cash surrender value of life insurance.
4. Investments in nonconsolidated subsidiaries or affiliated companies.

Companies expect to hold long-term investments for many years. They usually present them on the balance sheet just below “Current assets,” in a separate section called “Investments.” Realize that many securities classified as long-term investments are, in fact, readily marketable. But a company does not include them as current assets unless it intends to convert them to cash in the short-term—that is, within a year or in the operating cycle, whichever is longer. As indicated earlier, securities classified as available-for-sale are reported at fair value, and held-to-maturity securities are reported at amortized cost.

Motorola, Inc. reported its investments section, located between “Property, plant, and equipment” and “Other assets,” as shown in Illustration 5-10.

Property, Plant, and Equipment. Property, plant, and equipment are tangible long-lived assets used in the regular operations of the business. These assets consist of physical property such as land, buildings, machinery, furniture, tools, and wasting resources (timberland, minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., timberlands or oil reserves) these assets.

Mattel, Inc. presented its property, plant, and equipment in its balance sheet as shown in Illustration 5-11 (page 222).

A company discloses the basis it uses to value property, plant, and equipment; any liens against the properties; and accumulated depreciation—usually in the notes to the financial statements.

Intangible Assets. Intangible assets lack physical substance and are not financial instruments (see page 238 for the definition of a financial instrument). They include patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists. A company writes off (amortizes) limited-life intangible assets over their useful lives. It periodically assesses indefinite-life intangibles (such as goodwill) for impairment. Intangibles can represent significant economic resources, yet financial analysts often ignore them, because valuation is difficult.

PepsiCo, Inc. reported intangible assets in its balance sheet as shown in Illustration 5-12.

Other Assets. The items included in the section “Other assets” vary widely in practice. Some include items such as long-term prepaid expenses, prepaid pension cost, and noncurrent receivables. Other items that might be included are assets in special funds, deferred income taxes, property held for sale, and restricted cash or securities. A company should limit this section to include only unusual items sufficiently different from assets included in specific categories.

Liabilities

Similar to assets, companies classify liabilities as current or long-term.

Current Liabilities. Current liabilities are the obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities. This concept includes:

1. Payables resulting from the acquisition of goods and services: accounts payable, wages payable, taxes payable, and so on.
2. Collections received in advance for the delivery of goods or performance of services, such as unearned rent revenue or unearned subscriptions revenue.
3. Other liabilities whose liquidation will take place within the operating cycle, such as the portion of long-term bonds to be paid in the current period or short-term obligations arising from the purchase of equipment.

At times, a liability that is payable within the next year is not included in the current liabilities section. This occurs either when the company expects to refinance the debt through another long-term issue [3] or to retire the debt out of noncurrent assets. This approach is used because liquidation does not result from the use of current assets or the creation of other current liabilities.

Companies do not report current liabilities in any consistent order. In general, though, companies most commonly list notes payable, accounts payable, or short-term debt as the first item. Income taxes payable, current maturities of long-term debt, or other current liabilities are commonly listed last. For example, see Halliburton Company's current liabilities section in Illustration 5-13.

Current liabilities include such items as trade and nontrade notes and accounts payable, advances received from customers, and current maturities of long-term debt. If the amounts are material, companies classify income taxes and other accrued items separately. A company should fully describe in the notes any information about a secured liability—for example, stock held as collateral on notes payable—to identify the assets providing the security.

The excess of total current assets over total current liabilities is referred to as working capital (or sometimes net working capital). Working capital represents the net amount of a company's relatively liquid resources. That is, it is the liquidity buffer available to meet the financial demands of the operating cycle.

Companies seldom disclose on the balance sheet an amount for working capital. But bankers and other creditors compute it as an indicator of the short-run liquidity of a company. To determine the actual liquidity and availability of working capital to meet current obligations, however, requires analysis of the composition of the current assets and their nearness to cash.

Long-Term Liabilities. Long-term liabilities are obligations that a company does not reasonably expect to liquidate within the normal operating cycle. Instead, it expects to pay them at some date beyond that time. The most common examples are bonds payable, notes payable, some deferred income tax amounts, lease obligations, and pension obligations. Companies classify long-term liabilities that mature within the current operating cycle as current liabilities if payment of the obligation requires the use of current assets.

Generally, long-term liabilities are of three types:

1. Obligations arising from specific financing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable.
2. Obligations arising from the ordinary operations of the company, such as pension obligations and deferred income tax liabilities.
3. 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 service or product warranties and other contingencies.

Companies generally provide a great deal of supplementary disclosure for long-term liabilities because most long-term debt is subject to various covenants and restrictions for the protection of lenders.⁸

It is desirable to report any premium or discount separately as an addition to or subtraction from the bonds payable. Companies frequently describe the terms of all long-term liability agreements (including maturity date or dates, rates of interest, nature of obligation, and any security pledged to support the debt) in notes to the financial statements. Illustration 5-14 provides an example of this, taken from an excerpt from The Great Atlantic & Pacific Tea Company's financials.

Owners' Equity

The owners' equity (stockholders' equity) section is one of the most difficult sections to prepare and understand. This is due to the complexity of capital stock agreements and the various restrictions on stockholders' equity imposed by state corporation laws, liability agreements, and boards of directors. Companies usually divide the section into six parts:

For capital stock, companies must disclose the par value and the authorized, issued, and outstanding share amounts. A company usually presents the additional paid-in capital in one amount although subtotals are informative if the sources of additional capital are varied and material. The retained earnings amount may be divided between the unappropriated (the amount that is usually available for dividend distribution) and restricted (e.g., by bond indentures or other loan agreements) amounts. In addition, companies show any capital stock reacquired (treasury stock) as a reduction of stockholders' equity. Accumulated other comprehensive income includes such items as unrealized gains and losses on available-for-sale investments and unrealized gains and losses on certain derivative transactions. Noncontrolling interest (discussed in Chapter 4 and sometimes referred to as minority interest) is also shown as a separate item (where applicable) as a part of equity.

Illustration 5-15 (page 226) presents an example of the stockholders' equity section from Las Vegas Sands Corporation.

The ownership or stockholders' equity accounts in a corporation differ considerably from those in a partnership or proprietorship. Partners show separately their permanent capital accounts and the balance in their temporary accounts (drawing accounts). Proprietorships ordinarily use a single capital account that handles all of the owner's equity transactions.

Balance Sheet Format

One common arrangement that companies use in presenting a classified balance sheet is the account form. It lists assets, by sections, on the left side, and liabilities and stockholders' equity, by sections, on the right side. The main disadvantage is the need for a sufficiently wide space in which to present the items side by side. Often, the account form requires two facing pages.

To avoid this disadvantage, the report form lists the sections one above the other, on the same page. See, for example, Illustration 5-16, which lists assets, followed by liabilities and stockholders' equity directly below, on the same page.⁹

Infrequently, companies use other balance sheet formats. For example, companies sometimes deduct current liabilities from current assets to arrive at working capital. Or, they deduct all liabilities from all assets.

STATEMENT OF CASH FLOWS

Chapter 2 indicated that an important element of the objective of financial reporting is “assessing the amounts, timing, and uncertainty of cash flows.” The three financial statements we have looked at so far—the 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. But they do so to a limited extent. For instance, the income statement provides information about resources provided by operations but not exactly cash. The statement of stockholders' equity shows the amount of cash used to pay dividends or purchase treasury stock. Comparative balance sheets might show what assets the company has acquired or disposed of, and what liabilities it has incurred or liquidated.

Useful as they are, none of these statements presents a detailed summary of all the cash inflows and outflows, or the sources and uses of cash during the period. To fill this need, the FASB requires the statement of cash flows (also called the cash flow statement). [5]

Purpose of the 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. To achieve this purpose, the statement of cash flows reports the following: (1) the cash effects of operations during a period, (2) investing transactions, (3) financing transactions, and (4) the net increase or decrease in cash during the period.¹⁰

Reporting the sources, uses, and net increase or decrease in cash helps investors, creditors, and others know what is happening to a company's most liquid resource. Because most individuals maintain a checkbook and prepare a tax return on a cash basis, they can comprehend the information reported in the statement of cash flows.

The statement of cash flows provides answers to the following simple but important questions:

1. Where did the cash come from during the period?
2. What was the cash used for during the period?
3. What was the change in the cash balance during the period?

Content and Format of the Statement of Cash Flows

Companies classify cash receipts and cash payments during a period into three different activities in the statement of cash flows—operating, investing, and financing activities, defined as follows.

1. Operating activities involve the cash effects of transactions that enter into the determination of net income.
2. Investing activities include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plant, and equipment.
3. Financing activities involve liability and owners' equity items. They include (a) obtaining resources from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed.

Illustration 5-17 shows the basic format of the statement of cash flows.

Illustration 5-18 (page 230) graphs the inflows and outflows of cash classified by activity.

The statement's value is that it helps users evaluate liquidity, solvency, and financial flexibility. As stated earlier, liquidity refers to the “nearness to cash” of assets and liabilities. Solvency is the firm's ability to pay its debts as they mature. Financial flexibility is a company's ability to respond and adapt to financial adversity and unexpected needs and opportunities.

We have devoted Chapter 23 entirely to the detailed preparation and content of the statement of cash flows. The intervening chapters will cover several elements and complex topics that affect the content of a typical statement of cash flows. The presentation in this chapter is introductory—a reminder of the existence of the statement of cash flows and its usefulness.

Overview of the Preparation of the Statement of Cash Flows

Sources of Information

Companies obtain the information to prepare the statement of cash flows from several sources: (1) comparative balance sheets, (2) the current income statement, and (3) selected transaction data.

The following simple example demonstrates how companies use these sources in preparing a statement of cash flows.

On January 1, 2014, 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 2014, the company purchased land for $15,000. Illustration 5-19 shows the company's comparative balance sheets at the beginning and end of 2014.

Illustration 5-20 presents the income statement and additional information.

Preparing the Statement of Cash Flows

Preparing the statement of cash flows from these sources involves four steps:

1. Determine the net cash provided by (or used in) operating activities.
2. Determine the net cash provided by (or used in) investing and financing activities.
3. Determine the change (increase or decrease) in cash during the period.
4. Reconcile the change in cash with the beginning and the ending cash balances.

Net cash provided by operating activities is the excess of cash receipts over cash payments from operating activities. Companies determine this amount by converting net income on an accrual basis to a cash basis. To do so, they add to or deduct from net income those items in the income statement that do not affect cash. This procedure requires that a company analyze not only the current year's income statement but also the comparative balance sheets and selected transaction data.

Analysis of Telemarketing's comparative balance sheets reveals two items that will affect the computation of net cash provided by operating activities:

1. The increase in accounts receivable reflects a noncash increase of $41,000 in revenues.
2. The increase in accounts payable reflects a noncash increase of $12,000 in expenses.

Therefore, to arrive at net cash provided by operating activities, Telemarketing Inc. deducts from net income the increase in accounts receivable ($41,000), and it adds back to net income the increase in accounts payable ($12,000). As a result of these adjustments, the company determines net cash provided by operating activities to be $10,000, computed as shown in Illustration 5-21.

Next, the company determines its investing and financing activities. Telemarketing Inc.'s only investing activity was the land purchase. It had two financing activities. (1) Common stock increased $50,000 from the issuance of 50,000 shares for cash. (2) The company paid $14,000 cash in dividends. Knowing the amounts provided/used by operating, investing, and financing activities, the company determines the net increase in cash. Illustration 5-22 (page 232) presents Telemarketing Inc.'s statement of cash flows for 2014.

The increase in cash of $31,000 reported in the statement of cash flows agrees with the increase of $31,000 in cash calculated from the comparative balance sheets.

Significant Noncash Activities

Not all of a company's significant activities involve cash. Examples of significant non-cash activities are:

1. Issuance of common stock to purchase assets.
2. Conversion of bonds into common stock.
3. Issuance of debt to purchase assets.
4. Exchanges of long-lived assets.

Significant financing and investing activities that do not affect cash are not reported in the body of the statement of cash flows. Rather, these activities are reported in either a separate schedule at the bottom of the statement of cash flows or in separate notes to the financial statements. Such reporting of these noncash activities satisfies the full disclosure principle.

Illustration 5-23 shows an example of a comprehensive statement of cash flows. Note that the company purchased equipment through the issuance of $50,000 of bonds, which is a significant noncash transaction. In solving homework assignments, you should present significant noncash activities in a separate schedule at the bottom of the statement of cash flows.

Usefulness of the Statement of Cash Flows

“Happiness is a positive cash flow” is certainly true. Although net income provides a long-term measure of a company's success or failure, cash is its lifeblood. Without cash, a company will not survive. For small and newly developing companies, cash flow is the single most important element for survival. Even medium and large companies must control cash flow.

Creditors examine the cash flow statement carefully because they are concerned about being paid. They begin their examination by finding net cash provided by operating activities. A high amount indicates that a company is able to generate sufficient cash from operations to pay its bills without further borrowing. Conversely, a low or negative amount of net cash provided by operating activities indicates that a company may have to borrow or issue equity securities to acquire sufficient cash to pay its bills. Consequently, creditors look for answers to the following questions in the company's cash flow statements.

1. How successful is the company in generating net cash provided by operating activities?
2. What are the trends in net cash flow provided by operating activities over time?
3. What are the major reasons for the positive or negative net cash provided by operating activities?

You should recognize that companies can fail even though they report net income. The difference between net income and net cash provided by operating activities can be substantial. Companies such as W. T. Grant Company and Prime Motor Inn, for example, reported high net income numbers but negative net cash provided by operating activities. Eventually, both companies filed for bankruptcy.

In addition, substantial increases in receivables and/or inventory can explain the difference between positive net income and negative net cash provided by operating activities. For example, in its first year of operations, Hu Inc. reported a net income of $80,000. Its net cash provided by operating activities, however, was a negative $95,000, as shown in Illustration 5-24 (page 234).

Hu could easily experience a “cash crunch” because it has its cash tied up in receivables and inventory. If Hu encounters problems in collecting receivables, or if inventory moves slowly or becomes obsolete, its creditors may have difficulty collecting on their loans.

Financial Liquidity

Readers of financial statements often assess liquidity by using the current cash debt coverage. It indicates whether the company can pay off its current liabilities from its operations in a given year. Illustration 5-25 shows the formula for this ratio.

The higher the current cash debt coverage, the less likely a company will have liquidity problems. For example, a ratio near 1:1 is good. It indicates that the company can meet all of its current obligations from internally generated cash flow.

Financial Flexibility

The cash debt coverage provides information on financial flexibility. It 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. Illustration 5-26 shows the formula for this ratio. Notice its similarity to the current cash debt coverage. However, because it uses average total liabilities in place of average current liabilities, it takes a somewhat longer-range view.

The higher this ratio, the less likely the company will experience difficulty in meeting its obligations as they come due. It signals whether the company can pay its debts and survive if external sources of funds become limited or too expensive.

Free Cash Flow

A more sophisticated way to examine a company's financial flexibility is to develop a free cash flow analysis. Free cash flow is the amount of discretionary cash flow a company has. It can use this cash flow to purchase additional investments, retire its debt, purchase treasury stock, or simply add to its liquidity. Financial statement users calculate free cash flow as shown in Illustration 5-27.

In a free cash flow analysis, we first deduct capital spending, to indicate it is the least discretionary expenditure a company generally makes. (Without continued efforts to maintain and expand facilities, it is unlikely that a company can continue to maintain its competitive position.) We then deduct dividends. Although a company can cut its dividend, it usually will do so only in a financial emergency. The amount resulting after these deductions is the company's free cash flow. Obviously, the greater the amount of free cash flow, the greater the company's financial flexibility.

Questions that a free cash flow analysis answers are:

1. Is the company able to pay its dividends without resorting to external financing?
2. If business operations decline, will the company be able to maintain its needed capital investment?
3. What is the amount of discretionary cash flow that can be used for additional investment, retirement of debt, purchase of treasury stock, or addition to liquidity?

Illustration 5-28 is a free cash flow analysis using the cash flow statement for Nestor Company (shown in Illustration 5-23 on page 233).

This computation shows that Nestor has a positive, and substantial, net cash provided by operating activities of $411,750. Nestor's statement of cash flows reports that the company purchased equipment of $182,500 and land of $70,000 for total capital spending of $252,500. Nestor has more than sufficient cash flow to meet its dividend payment and therefore has satisfactory financial flexibility.

As you can see from looking back at Illustration 5-23 (page 233), Nestor used its free cash flow to redeem bonds and add to its liquidity. If it finds additional investments that are profitable, it can increase its spending without putting its dividend or basic capital spending in jeopardy. Companies that have strong financial flexibility can take advantage of profitable investments even in tough times. In addition, strong financial flexibility frees companies from worry about survival in poor economic times. In fact, those with strong financial flexibility often fare better in a poor economy because they can take advantage of opportunities that other companies cannot.

ADDITIONAL INFORMATION

In both Chapter 4 and this chapter, we have discussed the primary financial statements that all companies prepare in accordance with GAAP. However, the primary financial statements cannot provide the complete picture related to the financial position and financial performance of the company. Additional descriptive information in supplemental disclosures and certain techniques of disclosure expand on and amplify the items presented in the main body of the statements.

Supplemental Disclosures

The balance sheet is not complete if a company simply lists the assets, liabilities, and owners' equity accounts. It still needs to provide important supplemental information. This may be information not presented elsewhere in the statement, or it may elaborate on items in the balance sheet. The four types of information that are usually supplemental to account titles and amounts presented in the balance sheet are as follows.

Contingencies

A contingency is an existing situation involving uncertainty as to 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, contingencies are material events with an uncertain future. Examples of gain contingencies are tax operating-loss carryforwards or company litigation against another party. Typical loss contingencies relate to litigation, environmental issues, possible tax assessments, or government investigations. We examine the accounting and reporting requirements involving contingencies more fully in Chapter 13.

Accounting Policies

GAAP recommends disclosure for all significant accounting principles and methods that involve selection from among alternatives or those that are peculiar to a given industry. [6] For instance, companies can compute inventories under several cost flow assumptions (e.g., LIFO and FIFO), depreciate plant and equipment under several accepted methods (e.g., double-declining-balance and straight-line), and carry investments at different valuations (e.g., cost, equity, and fair value). Sophisticated users of financial statements know of these possibilities and examine the statements closely to determine the methods used.

Companies must also disclose information about the nature of their operations, the use of estimates in preparing financial statements, certain significant estimates, and vulnerabilities due to certain concentrations. [7] Illustration 5-29 shows an example of such a disclosure.

Disclosure of significant accounting principles and methods and of risks and uncertainties is particularly useful if given in a separate Summary of Significant Accounting Policies preceding the notes to the financial statements or as the initial note.

Contractual Situations

Companies should disclose contractual situations, if significant, in the notes to the financial statements. For example, they must clearly state the essential provisions of lease contracts, pension obligations, and stock option plans in the notes. Analysts want to know not only the amount of the liabilities but also how the different contractual provisions affect the company at present and in the future.

Companies must disclose the following commitments if the amounts are material: commitments related to obligations to maintain working capital, to limit the payment of dividends, to restrict the use of assets, and to require the maintenance of certain financial ratios. Management must exercise considerable judgment to determine whether omission of such information is misleading. The rule in this situation is, “When in doubt, disclose.” It is better to disclose a little too much information than not enough.

Fair Values

As we have discussed, fair value information may be more useful than historical cost for certain types of assets and liabilities. This is particularly so in the case of financial instruments. Financial instruments are defined as cash, an ownership interest, or a contractual right to receive or obligation to deliver cash or another financial instrument. Such contractual rights to receive cash or other financial instruments are assets. Contractual obligations to pay are liabilities. Cash, investments, accounts receivable, and payables are examples of financial instruments.

Given the expanded use of fair value measurements, as discussed in Chapter 2, GAAP also has expanded disclosures about fair value measurements. [8] To increase consistency and comparability in the use of fair value measures, companies follow a fair value hierarchy that provides insight into how to determine fair value. The hierarchy has three levels. Level 1 measures (the least subjective) are based on observable inputs, such as market prices for identical assets or liabilities. Level 2 measures (more subjective) 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 measures (most subjective) are based on unobservable inputs, such as a company's own data or assumptions.¹¹

For major groups of assets and liabilities, companies must make the following fair value disclosures: (1) the fair value measurement and (2) the fair value hierarchy level of the measurements as a whole, classified by Level 1, 2, or 3. Illustration 5-30 provides a disclosure for Devon Energy for its assets and liabilities measured at fair value.

In addition, companies must provide significant additional disclosure related to Level 3 measurements. The disclosures related to Level 3 are substantial and must identify what assumptions the company used to generate the fair value numbers and any related income effects. Companies will want to use Level 1 and 2 measurements as much as possible. In most cases, these valuations should be very reliable, as the fair value measurements are based on market information. In contrast, a company that uses Level 3 measurements extensively must be carefully evaluated to understand the impact these valuations have on the financial statements.

Techniques of Disclosure

Companies should disclose as completely as possible the effect of various contingencies on financial condition, the methods of valuing assets and liabilities, and the company's contracts and agreements. To disclose this pertinent information, companies may use parenthetical explanations, notes, cross-reference and contra items, and supporting schedules.

Parenthetical Explanations

Companies often provide additional information by parenthetical explanations following the item. For example, Illustration 5-31 shows a parenthetical explanation of the number of shares issued by Ford Motor Company on the balance sheet under “Stockholders' equity.”

This additional pertinent balance sheet information adds clarity and completeness. It has an advantage over a note because it brings the additional information into the body of the statement where readers will less likely overlook it. Companies, however, should avoid lengthy parenthetical explanations, which might be distracting.

Notes

Companies use notes if they cannot conveniently show additional explanations as parenthetical explanations. Illustration 5-32 shows how International Paper Company reported its inventory costing methods in its accompanying notes.

Companies commonly use notes to disclose the following: the existence and amount of any preferred stock dividends in arrears, the terms of or obligations imposed by purchase commitments, special financial arrangements and instruments, depreciation policies, any changes in the application of accounting principles, and the existence of contingencies.

Notes therefore must present all essential facts as completely and succinctly as possible. Careless wording may mislead rather than aid readers. Notes should add to the total information made available in the financial statements, not raise unanswered questions or contradict other portions of the statements. The note disclosures in Illustration 5-33 show the presentation of such information.

Cross-Reference and Contra Items

Companies “cross-reference” a direct relationship between an asset and a liability on the balance sheet. For example, as shown in Illustration 5-34, on December 31, 2014, a company might show the following entries—one listed among the current assets, and the other listed among the current liabilities.

This cross-reference points out that the company will redeem $2,300,000 of bonds payable currently, for which it has only set aside $800,000. Therefore, it needs additional cash from unrestricted cash, from sales of investments, from profits, or from some other source. Alternatively, the company can show the same information parenthetically.

Another common procedure is to establish contra or adjunct accounts. A contra account on a balance sheet reduces either an asset, liability, or owners' equity account. Examples include Accumulated Depreciation and Discount on Bonds Payable. Contra accounts provide some flexibility in presenting the financial information. With the use of the Accumulated Depreciation account, for example, a reader of the statement can see the original cost of the asset as well as the depreciation to date.

An adjunct account, on the other hand, increases either an asset, liability, or owners' equity account. An example is Premium on Bonds Payable, which, when added to the Bonds Payable account, describes the total bond liability of the company.

Supporting Schedules

Often a company needs a separate schedule to present more detailed information about certain assets or liabilities, as shown in Illustration 5-35.

Terminology

The account titles in the general ledger do not necessarily represent the best terminology for balance sheet purposes. Companies often use brief account titles and include technical terms that only accountants understand. But many persons unacquainted with accounting terminology examine balance sheets. Thus, balance sheets should contain descriptions that readers will generally understand and clearly interpret.

For example, companies have used the term “reserve” in differing ways: to describe amounts deducted from assets (contra accounts such as accumulated depreciation and allowance for doubtful accounts), as a part of the title of contingent or estimated liabilities, and to describe an appropriation of retained earnings. Because of the different meanings attached to this term, misinterpretation often resulted from its use. Therefore, the profession has recommended that companies use the word reserve only to describe an appropriation of retained earnings. The use of the term in this narrower sense—to describe appropriated retained earnings—has resulted in a better understanding of its significance when it appears in a balance sheet. However, the term “appropriated” appears more logical, and we encourage its use.

For years, the profession has recommended that the use of the word surplus be discontinued in balance sheet presentations of stockholders' equity. The use of the terms capital surplus, paid-in surplus, and earned surplus is confusing. Although condemned by the profession, these terms appear all too frequently in current financial statements.

SUMMARY OF LEARNING OBJECTIVES

Explain the uses and limitations of a balance sheet. The balance sheet provides information about the nature and amounts of investments in a company's resources, obligations to creditors, and owners' equity. The balance sheet contributes to financial reporting by providing a basis for (1) computing rates of return, (2) evaluating the capital structure of the enterprise, and (3) assessing the liquidity, solvency, and financial flexibility of the enterprise.

Three limitations of a balance sheet are as follows. (1) The balance sheet does not reflect fair value because accountants use a historical cost basis in valuing and reporting most assets and liabilities. (2) Companies must use judgments and estimates to determine certain amounts, such as the collectibility of receivables and the useful life of long-term tangible and intangible assets. (3) The balance sheet omits many items that are of financial value to the business but cannot be recorded objectively, such as human resources, customer base, and reputation.

Identify the major classifications of the balance sheet. The general elements of the balance sheet are assets, liabilities, and equity. The major classifications of assets are current assets; long-term investments; property, plant, and equipment; intangible assets; and other assets. The major classifications of liabilities are current and long-term liabilities. The balance sheet of a corporation generally classifies owners' equity as capital stock, additional paid-in capital, and retained earnings.

Prepare a classified balance sheet using the report and account formats. The report form lists liabilities and stockholders' equity directly below assets on the same page. The account form lists assets, by sections, on the left side, and liabilities and stockholders' equity, by sections, on the right side.

Indicate the purpose of the statement of cash flows. The primary purpose of a statement of cash flows is to provide relevant information about a company's cash receipts and cash payments during a period. Reporting the sources, uses, and net change in cash enables financial statement readers to know what is happening to a company's most liquid resource.

Identify the content of the statement of cash flows. In the statement of cash flows, companies classify the period's cash receipts and cash payments into three different activities. (1) Operating activities: Involve the cash effects of transactions that enter into the determination of net income. (2) Investing activities: Include making and collecting loans, and acquiring and disposing of investments (both debt and equity) and of property, plant, and equipment. (3) Financing activities: Involve liability and owners' equity items. Financing activities include (a) obtaining capital from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed.

Prepare a basic statement of cash flows. The information to prepare the statement of cash flows usually comes from comparative balance sheets, the current income statement, and selected transaction data. Companies follow four steps to prepare the statement of cash flows from these sources. (1) Determine the net cash provided by (or used in) operating activities. (2) Determine the net cash provided by (or used in) investing and financing activities. (3) Determine the change (increase or decrease) in cash during the period. (4) Reconcile the change in cash with the beginning and ending cash balances.

Understand the usefulness of the statement of cash flows. Creditors examine the statement of cash flows carefully because they are concerned about being paid. The net cash flow provided by operating activities in relation to the company's liabilities is helpful in making this assessment. Two ratios used in this regard are the current cash debt ratio and the cash debt ratio. In addition, the amount of free cash flow provides creditors and stockholders with a picture of the company's financial flexibility.

Determine which balance sheet information requires supplemental disclosure. Four types of information normally are supplemental to account titles and amounts presented in the balance sheet. (1) Contingencies: Material events that have an uncertain outcome. (2) Accounting policies: Explanations of the valuation methods used or the basic assumptions made concerning inventory valuation, depreciation methods, investments in subsidiaries, etc. (3) Contractual situations: Explanations of certain restrictions or covenants attached to specific assets or, more likely, to liabilities. (4) Fair values: Disclosures related to fair values, particularly related to financial instruments.

Describe the major disclosure techniques for the balance sheet. Companies use four methods to disclose pertinent information in the balance sheet. (1) Parenthetical explanations: Parenthetical information provides additional information or description following the item. (2) Notes: A company uses notes if it cannot conveniently show additional explanations or descriptions as parenthetical explanations. (3) Cross-reference and contra items: Companies “cross-reference” a direct relationship between an asset and a liability on the balance sheet. (4) Supporting schedules: Often a company uses a separate schedule to present more detailed information than just the single summary item shown in the balance sheet.

APPENDIX   5A RATIO ANALYSIS—A REFERENCE

USING RATIOS TO ANALYZE PERFORMANCE

Analysts and other interested parties can gather qualitative information from financial statements by examining relationships between items on the statements and identifying trends in these relationships. A useful starting point in developing this information is ratio analysis.

A ratio expresses the mathematical relationship between one quantity and another. Ratio analysis expresses the relationship among pieces of selected financial statement data, in a percentage, a rate, or a simple proportion.

To illustrate, IBM Corporation recently had current assets of $46,970 million and current liabilities of $39,798 million. We find the ratio between these two amounts by dividing current assets by current liabilities. The alternative means of expression are:

To analyze financial statements, we classify ratios into four types, as follows.

In Chapter 5, we discussed three measures related to the statement of cash flows (current cash debt coverage, cash debt coverage, and free cash flow). Throughout the remainder of the textbook, we provide ratios to help you understand and interpret the information presented in financial statements. Illustration 5A-1 presents the ratios that we will use throughout the textbook. You should find this chart helpful as you examine these ratios in more detail in the following chapters. An appendix to Chapter 24 further discusses financial statement analysis.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 5A

Identify the major types of financial ratios and what they measure. Ratios express the mathematical relationship between one quantity and another, expressed as a percentage, a rate, or a proportion. Liquidity ratios measure the short-term ability to pay maturing obligations. Activity ratios measure the effectiveness of asset usage. Profitability ratios measure the success or failure of an enterprise. Coverage ratios measure the degree of protection for long-term creditors and investors.

APPENDIX   5B SPECIMEN FINANCIAL STATEMENTS: THE PROCTER & GAMBLE COMPANY

The Procter & Gamble Company (P&G) manufactures and markets a range of consumer products in various countries throughout the world. The company markets over 300 branded products in more than 160 countries. It manages its business in six product segments: Fabric and Home Care, Baby and Family Care, Beauty Care, Health Care, Snacks, and Pet Care and Grooming.

The content and organization of corporate annual reports have become fairly standardized. Excluding the public relations part of the report (pictures, products, etc.), the following are the traditional financial portions of the annual report:

• Letter to the Stockholders
• Financial Highlights
• Management's Discussion and Analysis
• Management Certification of Financial Statements
• Management's Report on Internal Control
• Auditor's Reports
• Financial Statements
• Notes to the Financial Statements
• Supplementary Financial Information (e.g., 10-year financial summary)

The following pages contain excerpts from the president's letter and the financial statements from P&G's 2011 annual report. The complete P&G annual report can be accessed at the book's companion website, www.wiley.com/college/kieso. You will see examples of the standard annual report elements by examining the P&G annual report.

We do not expect that you will comprehend P&G's financial statements and the accompanying notes in their entirety at your first reading. But we expect that by the time you complete the material in this textbook, your level of understanding and interpretive ability will have grown enormously.

At this point, we recommend that you go online and take 20 to 30 minutes to scan the annual report, especially the financial statements and notes. Your goal should be to familiarize yourself with the contents and accounting elements. Throughout the following 19 chapters, when you are asked to refer to specific parts of P&G's financial statements, do so! Then, when you have completed reading this textbook, we challenge you to reread P&G's financials to see how much greater and more sophisticated your understanding of them has become.

Letter to Shareholders

Financials

Consolidated Statements of Earnings

Consolidated Balance Sheets

Consolidated Statements of Shareholders' Equity

Consolidated Statements of Cash Flows

Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.

Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS.