Chapter 2: Highlights

Chapter 2: Highlights

1.The balance sheet is one of the three principal financial statements. It derives its name from the fact that it shows the following balance, or equality:

Assets = Liabilities + Shareholders' Equity

The firm's resources (the assets) must equal the firm's claims on the resources (the liabilities and shareholders' equity). The balance sheet presents a listing of the specific forms (for example cash, inventory, equipment) in which a firm holds resources and a listing of the people or entities that provided the financing and therefore have a claim on the resources.

2.An asset is a resource that has the potential for providing a firm with future economic benefits. The resources recognized as assets are those (a) for which the firm has acquired rights to their use in the future through a past transaction or exchange, and (b) for which the firm can measure or quantify the future benefits with a reasonable degree of precision. Assets are future benefits; not all future benefits are assets.

3.Accounting must assign a monetary amount to each asset on the balance sheet. Methods for determining this amount include: (a) acquisition or historical cost, (b) current replacement cost, (c) current net realizable value, and (d) present value of future net cash flows.

4.The acquisition, or historical, cost is the amount of cash payment (or cash equivalent value) made in acquiring an asset.

5.Current replacement cost (an entry value) represents the amount required currently to acquire the rights to receive future benefits from the asset.

6.Net realizable value (an exit value) is the net amount of cash (selling price less selling costs) that the firm would receive currently if it sold the asset.

7.The future benefits from an asset come from the asset's ability to generate future cash receipts or reduce future cash expenditures. A final way to express the valuation of an asset is in terms of the asset's present value, representing today's value of the stream of future cash flows. Because cash can earn interest over time, the present value is worth less than the sum of the cash amounts to be received or saved over time. If future cash flows are to measure an asset’s value, then accountants will discount the future net cash flows to find their present value as of the date of the balance sheet. Using discounted cash flows in the valuation of individual assets requires solving difficulties of: (a) the uncertainty of the amounts of future cash flows, (b) how to allocate the cash receipts from the sale of merchandise to all of the assets involved in its production and distribution, and (c) how to select the appropriate rate to use in discounting the future cash flows to the present.

8.Financial statements prepared by publicly held firms are based primarily on one of two valuation methods, one for monetary assets and one for nonmonetary assets. Monetary assets, such as cash and accounts receivable, appear at their current cash or cash-equivalent value. Nonmonetary assets, such as merchandise inventory, land, buildings, and equipment, appear at acquisition cost, and in some cases adjusted downward to reflect the services of the assets that the firm has consumed. Three important accounting concepts or conventions support the use of acquisition cost: (a) the going concern concept, (b) reliability, and (c) the conservatism convention.

9.The going concern concept assumes the firm will remain in operations long enoughto carry out all of its current plans.

10. Reliability refers to the ability of a measure, such as acquisition cost, to faithfully represent what it purports to measure. Reliability also encompasses the ability to verify, or audit, the measured amount.

11.Conservatism has evolved as a convention to justify acquisition cost valuations. Acquisition cost generally provides more conservative valuations of assets (and measures of earnings) relative to other methods. Many accountants feel that the possibility of misleading financial statements users will be minimized when assets are stated at lower rather than higher amounts.

12.The classification of assets within the balance sheet varies widely from firm to firm, but the principal asset categories are usually: (a) current assets, (b) investments, (c) property, plant, and equipment, and (d) intangible assets. Current assets include cash and other assets that a firm expects to realize in cash or sell or consume during the normal operating cycle. Investments include primarily long-term investments in securities of other firms. Property, plant, and equipment includes the tangible, long-lived assets used in a firm's operations and generally not acquired for resale. The balance sheet shows these items (except land) at acquisition cost reduced by the accumulated depreciation since the firm acquired the assets. Intangibles are long-lived assets that lack physical substance, such as patents, trademarks, and franchises.

13.A liability is an obligation that arises when a firm receives benefits or services and in exchange promises to pay the provider of those goods or services a reasonably definite amount at a reasonably definite future time. All liabilities are obligations; not all obligations, however, are accounting liabilities.

14.Most liabilities are monetary in nature, requiring payments of specific amounts of cash. Firms report monetary liabilities due within one year or less at the amount of cash the firm expects to pay to discharge the liability. Those liabilities with due dates extending more than one year into the future appear at the present values of the future cash outflows. Liabilities that firms discharge by delivering goods or rendering services are nonmonetary items and appear at the amount of cash received or the estimated cost of providing the service.

15. Contingent liabilities, such as a loan guarantee or an unsettled lawsuit, require some future event to occur before accounting can establish the existence and amount of a liability. Obligations created by mutually unexecuted contracts, such as leases or employment contracts, are not recognized as liabilities.

16.Firms typically classify liabilities in the balance sheet in one of the following categories: (a) current liabilities, (b) long-term debt, and (c) other long-term liabilities. Current liabilities are obligations that a firm expects to pay or discharge during the normal operating cycle (they are usually paid using current assets). Long-term debt are those obligations having due dates more than one year from the balance sheet date. Obligations not properly considered as current liabilities or long-term debt appear as other long-term liabilities.

17.The owners' (shareholders') equity, or interest, in a firm is a residual interest, because the owners have a claim only against those assets not required to meet the claims of creditors. Since owners' equity is a residual interest, its valuation on the balance sheet reflects the valuation of assets and liabilities (that is, assets – liabilities = owners’ equity).

18.Corporations divide the owners' (shareholders') equity section into two sections, contributed capital and retained earnings. Contributed capital represents amounts shareholders provide for an interest in the firm (that is, common stock). Retained earnings are earnings subsequently realized by the firm in excess of dividends declared.

19.Corporations typically further disaggregate contributed capital into the par or stated value of the shares and amounts contributed in excess of par value or stated value. The par or stated value of a share of stock is a somewhat arbitrary amount assigned to comply with corporation laws of each state. The par or stated value rarely equals the market price of the shares at the time the firm issues them.

20.Firms organized as sole proprietorships or partnerships do not make a distinction between contributed capital and retained earnings in their balance sheet. The balance sheet reports a capital account for each owner containing their share of capital contributions plus their share of earnings in excess of distributions.

21.The balance sheet provides a constant equality between total assets and total equities (liabilities plus owners' equity). Any single transaction has a dual effect in maintaining this equality by either a/an:

a.Increase in an asset and an increase in either a liability or shareholders' equity;

b.Decrease in an asset and a decrease in either a liability or shareholders' equity;

c.Increase in one asset and a decrease in another asset;

d.Increase in one liability or shareholders' equity and a decrease in another liability or shareholders' equity.

1. Firms use accounts to record the dual effect of transactions. An account must provide for accumulating the increases and decreases (if any) that occur during a period for each balance sheet item. A T-account serves the purpose of an account for textbooks, problems, and examinations. A T-account looks like the letter T. The account title appears on top of the horizontal line. One side of the space formed by the vertical line records increases in the item and the other side decreases. Long-standing custom follows these rules:
2. Increases in assets appear on the left side and decreases in assets appear on the right side.
3. Increases in liabilities appear on the right side and decreases in liabilities appear on the left side.
4. Increases in shareholders’ equity appear on the right side and decreases in shareholders equity appear on the left side.

1. Common practice refers to entries on the left side of accounts as debits and entries on the right side of accounts as credits. Thus, debits indicate increases in assets or decreases in liabilities or shareholders’ equity. Credits indicate decreases in assets or increases in liabilities or shareholders’ equity.

24.Firms also use journal entries to record the dual effects of a transaction as to both accounts and amounts. Accountants refer to the first line of the journal entry as the debit line and the second line of the journal entry as the credit line. The standard journal entry format is:

Date

Account Debited

/

Account Debited

Account Credited /

Account Credited

Journal entries throughout the textbook also show the effect of the entry on the balance sheet equation using the format below. (Class.) indicates the effect on shareholders’ equity. This accounting equation is not normally part of the journal entry.

Assets / = / Liabilities / + / Shareholders' Equity / (Class.)

The journal entry also includes an explanation of the effect journalized.

Explanation for transaction or event recorded.

25.The preparation of a balance sheet requires that you recognize and understand the meaning of a large list of account titles that are commonly used. Careful attention should be given to this discussion in the text.

26.Analysts often use a common-size balance sheet to study the nature and mix of assets and their financing. In a common-size balance sheet, the analyst expresses each balance sheet item as a percentage of total assets or total liabilities plus shareholders’ equity.

27.The balance sheet reflects the effects of a firm's investing and financing decisions. The user of the balance sheet should consider if the firm has the right mix of financing for its assets. Two principles guide decisions about financing:

a.Firms generally use short-term financing for assets that a firm expects to turn into cash soon, and long-term financing (long-term debt or shareholders’ equity) for assets that a firm expects to turn into cash over a longer period.

b.The mix of long-term financing depends on the nature of long-term assets and the amount of operating risk in the business.

-Firms with tangible long-term assets and predictable cash flows tend to use a high proportion of long-term debt.

-Firms with tangible long-term assets but less predictable cash flows tend to use a more balanced mix of long-term debt and shareholders’ equity financing.

-Firms with high proportion of intangibles tend to use low proportions of long-term debt.

28.The balance sheet does not always provide useful data because, as a result of following GAAP,

1. Not all resources of a firm appear on the balance sheet as assets,

1. Not all obligations of a firm appear on the balance sheet as liabilities,

1. Assets on the balance sheet do not typically reflect current market valuations, and

1. Liabilities on the balance sheet do not necessarily reflect current market valuations.

The user of the balance sheet should recognize these weaknesses when attempting to assess the financial condition of a firm.

29.The format, terminology, and accounting principles of the balance sheet in other countries sometimes differ from that used in the United States. An understanding of the concepts underlying the balance sheet in the United States should aid understanding of differences encountered in other countries.