Intermediate Accounting 14th Chapter 5

Questions 1.

The balance sheet provides information about the nature and amounts of investments in enterprise resources, obligations to enterprise creditors, and the owners’ equity in net enterprise resources. That information not only complements information about the components of income, but also 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 and financial flexibility of the enterprise. Solvency refers to the ability of an enterprise 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. Information on long-term obligations, such as long-term debt and notes payable, in comparison to total assets can be used to assess resources that will be needed to meet these fixed obligations (such as interest and principal payments). Financial flexibility is 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.

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An enterprise 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 the financial flexibility, the lower the risk of enterprise failure. Some situations in which estimates affect amounts reported in the balance sheet include: (a)allowance for doubtful accounts. (b)depreciable lives and estimated salvage values for plant and equipment. (c)warranty returns. d)determining the amount of revenues that should be recorded as unearned. 5An increase in inventories increases current assets, which is in the numerator of the current ratio. Therefore, inventory increases will increase the current ratio. In general, an increase in the current ratio indicates a company has better liquidity, since there are more current assets relative to current liabilities. 6. Liquidity describes the amount of time that is expected to elapse until an asset is converted into cash or until a liability has to be paid.

The ranking of the assets given in order of liquidity is:

• Short-term investments.
• Accounts receivable.
• Inventory.
• Buildings.
• Goodwill.

The major limitations of the balance sheet are: The values stated are generally historical and not at fair value. (b)Estimates have to be used in many instances, such as in the determination of collectibility of receivables or finding the approximate useful life of long-term tangible and intangible assets. c)Many items, even though they have financial value to the business, presently are not recorded. One example is the value of a company’s human resources. Some items of value to technology companies such as Intel or IBM are the value of research and development (new products that are being developed but which are not yet marketable), the value of the “intellectual capital” of its workforce (the ability of the companies’ employees to come up with new ideas and products in the fast changing technology industry), and the value of the company reputation or name brand (e. . , the “Intel Inside” logo). In most cases, the reasons why the value of these items are not recorded in the balance sheet concern the lack of faithful representation of the estimates of the future cash flows that will be generated by these “assets” (for all three types) and the ability to control the use of the asset (in the case of employees). Being able to reliably measure the expected future benefits and to control the use of an item are essential elements of the definition of an asset, according to the Conceptual Framework.

Classification in financial statements helps users by grouping items with similar characteristics and separating items with different characteristics. Current assets are expected to be converted to cash within one year or one operating cycle, whichever is longer—property, plant and equipment will provide cash inflows over a longer period of time. Thus, separating long-term assets from current assets facilitates computation of useful ratios such as the current ratio. Separate amounts should be reported for accounts receivable and notes receivable.

The amounts should be reported gross, and an amount for the allowance for doubtful accounts should be deducted. The amount and nature of any nontrade receivables, and any amounts designated or pledged as collateral, should be clearly identified. No. Available-for-sale securities should be reported as a current asset only if management expects to convert them into cash as needed within one year or the operating cycle, whichever is longer. If available-for-sale securities are not held with this expectation, they should be reported as long-term investments. The relationship between current assets and current liabilities is that current liabilities are those obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities. The total selling price of the season tickets is $20,000,000 (10,000 X $2,000). Of this amount, $8,000,000 has been earned by 12/31/12 (16/40 X $20,000,000). The remaining $12,000,000 should be reported as unearned revenue, a current liability in the 12/31/12 balance sheet (24/40 X $20,000,000).

Working capital is the excess of total current assets over total current liabilities. This excess is sometimes called 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. Shareholders’ Equity. “Treasury stock (at cost). ” (b)Current Assets. Included in “Cash. ” (c)Investments. “Land held as an investment. ” (d)Investments. “Sinking fund. ” (e)Long-term debt (adjunct account to bonds payable). Unamortized premium on bonds payable. ” (f)Intangible Assets. “Copyrights. ” (g)Investments. “Employees’ pension fund,” with subcaptions of “Cash” and “Securities” if desired. (Assumes that the company still owns these assets. ) (h)Shareholders’ Equity. “Premium on capital stock” or “Additional paid-in capital. ” (i)Investments. Nature of investments should be given together with parenthetical information as follows: “pledged to secure loans payable to banks. ” Allowance for doubtful accounts receivable should be deducted from accounts receivable in current assets. Merchandise held on consignment should not appear on the consignee’s balance sheet except possibly as a note to the financial statements. (c)Advances received on sales contract are normally a current liability and should be shown as such in the balance sheet. Cash surrender value of life insurance should be shown as a long-term investment. Land should be reported in property, plant, and equipment unless held for investment. Merchandise out on consignment should be shown among current assets under the heading of inventories. (g)Franchises should be itemized in a section for intangible assets. h)Accumulated depreciation of plant and equipment should be deducted from the plant and equipment accounts. (i)Materials in transit should not be shown on the balance sheet of the buyer, if purchased f. o. b. destination. Trade accounts receivable should be stated at their estimated amount collectible, often referred to as net realizable value. The method most generally followed is to deduct from the total accounts receivable the amount of the allowance for doubtful accounts. Land is generally stated in the balance sheet at cost. (c)Inventories are generally stated at the lower of cost or market. d)Trading securities (consisting of common stock of other companies) are stated at fair value. Prepaid expenses should be stated at cost less the amount apportioned to and written off over the previous accounting periods. Assets are defined as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. If a building is leased under a capital lease, the future economic benefits of using the building are controlled by the lessee (tenant) as the result of a past event (the signing of a lease agreement). 19. Battle is incorrect.

Retained earnings is a source of assets, but is not an asset itself. For example, even though the funds obtained from issuing a note payable are invested in the business, the note payable is not reported as an asset. It is a source of assets, but it is reported as a liability because the company has an obligation to repay the note in the future. Similarly, even though the earnings are invested in the business, retained earnings is not reported as an asset. It is reported as part of shareholders’ equity because it is, in effect, an investment by owners which increases the ownership interest in the assets of an entity.

The notes should appear as long-term liabilities with full disclosure as to their terms. Each year, as the profit is determined, notes of an amount equal to two-thirds of the year’s profits should be transferred from the long-term liabilities to current liabilities until all of the notes have been liquidated. The 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. It differs from the balance sheet and the income statement in that it reports the sources and uses of cash by operating, investing, and financing activity classifications.

While the income statement and the balance sheet are accrual basis statements, the statement of cash flows is a cash basis statement—noncash items are omitted. The difference between these two amounts may be due to increases in current assets (e. g. , an increase in accounts receivable from a sale on account would result in an increase in revenue and net income but have no effect yet on cash). Similarly a cash payment that results in a decrease in an existing current liability (e. g. , accounts payable would decrease cash provided by operations without affecting net income). The difference between these two amounts could be due to noncash charges that appear in the income statement. Examples of noncash charges are depreciation, depletion, and amortization of intangibles. Expenses recorded but unpaid (e. g. , increase in accounts payable) and collection of previously recorded sales on credit (i. e. , now decreasing accounts receivable) also would cause cash provided by operating activities to exceed net income. Operating activities involve the cash effects of transactions that enter into the determination of net income.

Investing activities include making and collecting loans and acquiring and disposing of debt and equity instruments; property, plant, and equipment and intangibles. Financing activities involve liability and owners’ equity items and include obtaining capital from owners and providing them with a return on (dividends) and a return of their investment and borrowing money from creditors and repaying the amounts borrowed. Net income is adjusted downward by deducting $5,000 from $90,000 and reporting cash provided by operating activities as $85,000. The issuance of the preferred stock is a financing activity.

 The company appears to have good liquidity and reasonable financial flexibility. Its current cash debt coverage ratio is 1. 20, which indicates that it can pay off its current liabilities in a given year from its operation. In addition its cash debt coverage ratio is also good at . 80 which indicates it can pay off approximately 80% of its debt out of current operations. Free cash flow = $860,000 – $75,000 – $30,000 = $755,000. Free cash flow is net cash provided by operating activities less capital expenditures and dividends.

The purpose of free cash flow analysis is to determine the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity and financial flexibility. 29. Some of the techniques of disclosure for the balance sheet are: Parenthetical explanations. Notes to the financial statements. Cross references and contra items. Supporting schedules. A note entitled “Summary of Significant Accounting Policies” would indicate the basic accounting principles used by that enterprise.

This note should be very useful from a comparative standpoint, since it should be easy to determine whether the company uses the same accounting policies as other companies in the same industry. 31. General debt obligations, lease contracts, pension arrangements and stock option plans are four items for which disclosure is mandatory in the financial statements. The reason for disclosing these contractual situations is that these commitments are of a long-term nature, are often significant in amount, and are very important to the company’s well-being.

The profession has recommended that the use of the word “surplus” be discontinued in balance sheet presentations of owners’ equity. This term has a connotation outside accounting that is quite different from its meaning in the accounts or in the balance sheet. The use of the terms capital surplus, paid-in surplus, and earned surplus is confusing to the non-accountant and leads to misinterpretation.

Exercise

If the investment in preferred stock is readily marketable and held primarily for sale in the near term to generate income on short-term price differences, then the account should appear as a current asset and be included with trading investments. If, on the other hand, the preferred stock is not a trading security, it should be classified as available-for-sale. Available for sale securities are classified as current or non-current depending upon the circumstances. If the company accounts for the treasury stock on the cost basis, the account should properly be shown as a reduction of total shareholders’ equity. Shareholders’ equity. Current liability. Property, plant, and equipment (as a deduction). If an asset in process of construction is being constructed for another party, it is properly classified as an inventory account in the current asset section. This account will be shown net of any billings on the contract. On the other hand, if the asset is being constructed for the use of this particular company, it should be classified as a separate item in the property, plant, and equipment section.

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