Understanding Balance Sheet & Cash Flow: Uses, Limitations, Classifications, Study notes of Financial Accounting

Download Understanding Balance Sheet & Cash Flow: Uses, Limitations, Classifications and more Study notes Financial Accounting in PDF only on Docsity! Chapter 5 1 Ch. 5 - Balance Sheet and Statement of Cash Flows I. Uses and limitations of a balance sheet A. Uses 1. To provide information related to: Liquidity The amount of time until an asset is realized or otherwise converted into cash. Financial flexibility The ability of an enterprise to take effective action to alter the amounts and timing of cash flow. 2. Aids in assessing risk and predicting future cash flows. B. Limitations (1) failure to reflect current value information, (2) the extensive use of estimates, and (3) failure to include items of financial value that cannot be recorded objectively. Assets - human resources, managerial skills, customer base, and reputation Liabilities- leases and certain contractual arrangements are reported in an "off balance sheet" manner. C. So, why not used current value? Reliability!! (One of the two primary qualitative characteristics of accounting information.) II. Major classifications of the balance sheet. A. Assets - Probable future economic benefits. 1. Current assets Cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. Current assets are presented in order of liquidity. Items in the current asset section, include:. Chapter 5 2 a. Unrestricted Cash— any cash restricted for purposes other than current obligations is excluded from current assets. b. Short-term investments - classified as either: 1. trading - reported at FMV 2. available-for-sale - reported at FMV 3. held-to-maturity - reported at amortized cost. c. Receivables Must also disclose: 1. the amounts of expected uncollectibles 2. nontrade receivables 3. accounts pledged or discounted d. Inventories Must also disclose: 1. The basis of valuation (e.g., lower of cost or market) 2. pricing method (e.g., FIFO, LIFO, etc.) 3. stage of completion e. Prepaid expenses Any non-current prepaids are reported as deferred charges in the "other asset" section. 2. Noncurrent assets a. Long-term investments Key is that management intent is to hold these investments for an extended period of time. Items included here are: 1. Investments in securities 2. Investments in tangible fixed assets not currently used in operations: land held for speculation. 3. Investments set aside in special funds: sinking funds, pension funds, plant expansion funds. 4. Investments in non-consolidated subsidiaries or affiliated companies. Chapter 5 5 b. With regard to bonds, any premium or discount on bonds payable is disclosed separately as an addition to or subtraction from the bonds. Theoretically any premium or discount related to the current portion of LT bonds should also be reclassified as current. c. Additonal disclosure required for: 1. debt covenants and restrictions 2. terms of the debt such as maturity dates, interest rates, and amounts of any securities pledged to support the debt. C. Equity 1. Stockholders' equity of corporations. a. Capital stock— carried at the par or stated value of the shares issued. 1. The authorized, issued, and outstanding par value amounts must be disclosed. Treasury stock is shown as a rediuction of stockholders' equity. 2. Additional paid-in capital— primarily the excess of amounts paid in over the par or stated value. b. Retained earnings The undistributed earnings of the corporation. Must disclose any appropriated (restricted) retained earnings. III. Other points to consider in Chapter 5 A. Working capital - the excess of current assets over current liabilities. B. Contingencies— Events that have an uncertain outcome which may have a material effect on financial position. 1. Gain contingencies are not recorded; disclosed only if probability of receipt is high. 2. Loss contingencies— general rules: a. Loss probable and reasonably estimable— record a loss and a liability or contra-asset. b. Loss reasonably possible— disclose in the notes. c. Loss remote— no disclosure is necessary. 3. General risk contingencies need not be disclosed. Chapter 5 6 C. Post-balance sheet events (subsequent events) Events that occur after the formal date of the balance sheet but before it is issued. Two types: 1. First type of subsequent event: Events that require adjustment of the financial statements before they are issued. a. These events provide additional evidence about estimated items or conditions that already existed at the balance sheet date. b. The information provided by these events would have been recorded if it had been available at the balance sheet date. c. Examples: 1. Settlement of lawsuits from claims arising before the balance sheet date. 2. Final determination of loss from natural disasters such as tornados or floods that occurred before the balance sheet date. 3. Loss on an uncollectible account where customer's deteriorating financial condition led to bankruptcy after the balance sheet date. 2. Second type of subsequent event: Events that require disclosure in, but not adjustment of, the financial statements before they are issued. a. These events provide evidence about conditions that did not exist at the balance sheet date. b. Examples: 1. Sale of bonds or capital stock. 2. Purchase of a business. 3. Loss of plant or inventories from fire or flood. 4. Loss on an uncollectible account due to customer's fire loss occurring after the balance sheet date.