The usefulness of the balance sheet is enhanced when assets and liabilities are grouped according to common characteristics. The broad distinction made in the balance sheet is the current versus noncurrent classification of both assets and liabilities. The remainder of Part A provides an overview of the balance sheet. We discuss each of the three primary elements of the balance sheet (assets, liabilities, and shareholders' equity) in the order they are reported in the statement as well as the classifications typically made within the elements. The balance sheet elements were defined in Chapter 1 as follows:
Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
Equity (or net assets), called shareholders' equity or stockholders' equity for a corporation, is the residual interest in the assets of an entity that remains after deducting liabilities.
The key classification of assets and liabilities in the balance sheet is the current versus noncurrent distinction.
Graphic 3-1 lists the balance sheet elements along with their sub-classifications.
We intentionally avoid detailed discussion of the question of valuation in order to focus on an overview of the balance sheet. In later chapters we look closer at the nature and valuation of the specific assets and liabilities.
Classification of Elements within a Balance Sheet
Current assets include cash and other assets that are reasonably expected to be converted to cash or consumed within the coming year, or within the normal operating cycle of the business if that's longer than one year. The operating cycle period of time necessary to convert cash to raw materials, raw materials to finished product, the finished product to receivables, and then finally receivables back to cash. for a typical manufacturing company refers to the period of time necessary to convert cash to raw materials, raw materials to a finished product, the finished product to receivables, and then finally receivables back to cash. This concept is illustrated in Graphic 3-2.
In some businesses, such as shipbuilding or distilleries, the operating cycle extends far beyond one year. For example, if it takes two years to build an oil-carrying supertanker, then the shipbuilder will classify as current those assets that will be converted to cash or consumed within two years. But for most businesses the operating cycle will be shorter than one year. In these situations the one-year convention is used to classify both assets and liabilities. Where a company has no clearly defined operating cycle, the one-year convention is used.
Current assets include cash and all other assets expected to become cash or be consumed within one year or the operating cycle, whichever is longer.
Graphic 3-3 presents the current asset sections of Dell Inc.'s 2009 and 2008 balance sheets (statements of financial position) that also can be located in the company's financial statements in Appendix B at the back of the text. In keeping with common practice, the individual current assets are listed in the order of their liquidity (nearness to cash).
Operating Cycle of a Typical Manufacturing Company
Cash and Cash Equivalents. The most liquid asset, cash, is listed first. Cash includes cash on hand and in banks that is available for use in the operations of the business and such items as bank drafts, cashier's checks, and money orders. Cash equivalents certain negotiable items such as commercial paper, money market funds, and U.S. Treasury bills that are highly liquid investments quickly convertible to cash. Short-term, highly liquid investments that can be readily converted to cash with little risk of loss. frequently include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. These are highly liquid investments that can be quickly converted into cash. Most companies draw a distinction between investments classified as cash equivalents and the next category of current assets, short-term investments, according to the scheduled maturity of the investment. It is common practice to classify investments that have a maturity date of three months or less from the date of purchase as cash equivalents. Dell Inc.'s policy follows this practice and is disclosed in the summary of significant accounting policies disclosure note. The portion of the note from the company's 2009 financial statements is shown in Graphic 3-4.
Current Assets—Dell Inc.
Real World Financials
Disclosure of Cash Equivalents—Dell Inc.
Real World Financials
Note 1—Description of Business and Summary of Significant Accounting Policies
Cash and Cash Equivalents
All highly liquid investments, including credit card receivables, due from banks, with original maturities of three months or less at date of purchase are carried at cost and are considered to be cash equivalents. All other investments not considered to be cash equivalents are separately categorized as investments.
Cash that is restricted for a special purpose and not available for current operations should not be classified as a current asset. For example, if cash is being accumulated to repay a debt due in five years, the cash is classified as investments, a noncurrent asset.2
Liquid investments not classified as cash equivalents are reported as either short-term investments investments not classified as cash equivalents that will be liquidated in the coming year or operating cycle, whichever is longer., sometimes called temporary investments or short-term marketable securities. Investments in stock and debt securities of other corporations are included as short-term investments if the company has the ability and intent to sell those securities within the next 12 months or operating cycle, whichever is longer. If, for example, a company owns 1,000 shares of IBM Corporation stock and intends to hold those shares for several years, the stock is a long-term investment and should be classified as a noncurrent asset, investments.
For reporting purposes, investments in debt and equity securities are classified in one of three categories: (1) held to maturity, (2) trading securities, or (3) securities available for sale. We discuss these different categories and their accounting treatment in Chapter 12.
Investments are classified as current if management has the ability and intent to liquidate the investment in the near term.
Accounts receivable receivables resulting from the sale of goods or services on account. result from the sale of goods or services on credit. Notice in Graphic 3-3 that Dell's accounts receivable and financing receivables (discussed in Chapter 7) are valued net, that is, less the amount not expected to be collected. Accounts receivable often are referred to as trade receivables because they arise in the course of a company's normal trade. Nontrade receivables result from loans or advances by the company to individuals and other entities. When receivables are supported by a formal agreement or note that specifies payment terms they are called notes receivable receivables supported by a formal agreement or note that specifies payment terms..
Accounts receivable usually are due in 30 to 60 days, depending on the terms offered to customers and are, therefore, classified as current assets. Any receivable, regardless of the source, not expected to be collected within one year or the operating cycle, whichever is longer, is classified as a noncurrent asset, investments.
Inventories goods awaiting sale (finished goods), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials). include goods awaiting sale (finished goods), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials). Inventory for a wholesale or retail company consists only of finished goods, but the inventory of a manufacturer will include all three types of goods. Occasionally, a manufacturing company will report all three types of inventory directly in the balance sheet. More often, only the total amount of inventories is shown in the balance sheet and the balances of each type are shown in a disclosure note. For example, the note shown in Graphic 3-5 lists the components of inventory in the 2009 financial statements of Dell Inc.
Inventories consist of assets that a retail or wholesale company acquires for resale or goods that manufacturers produce for sale.
Inventories Disclosure—Dell Inc.
Real World Financials
Inventories are reported as current assets because they normally are sold within the operating cycle.
Prepaid Expenses. Recall from Chapter 2 that a prepaid expense represents an asset recorded when an expense is paid in advance, creating benefits beyond the current period. represents an asset recorded when an expense is paid in advance, creating benefits beyond the current period. Examples are prepaid rent and prepaid insurance. Even though these assets are not converted to cash, they would involve an outlay of cash if not prepaid.
Whether a prepaid expense is current or noncurrent depends on when its benefits will be realized. For example, if rent on an office building were prepaid for one year, then the entire prepayment is classified as a current asset. However, if rent were prepaid for a period extending beyond the coming year, a portion of the prepayment is classified as an other asset, a noncurrent asset.3 Dell Inc. includes prepaid expenses in the other current assets category. Other current assets also include assets—such as nontrade receivables—that, because their amounts are not material, did not warrant separate disclosure.
When assets are expected to provide economic benefits beyond the next year, or operating cycle, they are reported as noncurrent assets. Typical classifications of noncurrent assets are (1) investments, (2) property, plant, and equipment, and (3) intangible assets.
INVESTMENTS. Most companies occasionally acquire assets that are not used directly in the operations of the business. These assets include investments in equity and debt securities of other corporations, land held for speculation, noncurrent receivables, and cash set aside for special purposes (such as for future plant expansion). These assets are classified as noncurrent because management does not intend to convert the assets into cash in the next year (or the operating cycle if that's longer).
Investments are assets not used directly in operations.
PROPERTY, PLANT, AND EQUIPMENT. Virtually all companies own assets classified as property, plant, and equipment land, buildings, equipment, machinery, autos, and trucks.. The common characteristics these assets share are that they are tangible, long-lived, and used in the operations of the business. Property, plant, and equipment, along with intangible assets, often are the primary revenue-generating assets of the business.
Property, plant, and equipment includes land, buildings, equipment, machinery, and furniture, as well as natural resources, such as mineral mines, timber tracts, and oil wells. These various assets usually are reported as a single amount in the balance sheet, with details provided in a note. They are reported at original cost less accumulated depreciation (or depletion for natural resources) to date. Quite often, a company will present only the net amount of property, plant, and equipment in the balance sheet and provide details in a disclosure note. Land often is listed as a separate item in this classification because it has an unlimited useful life and thus is not depreciated.
Tangible, long-lived assets used in the operations of the business are classified as property, plant, and equipment.
INTANGIBLE ASSETS. Some assets used in the operations of a business have no physical substance. These are appropriately called intangible assets operational assets that lack physical substance; examples include patents, copyrights, franchises, and goodwill.. Generally, these represent the ownership of an exclusive right to something such as a product, a process, or a name. This right can be a valuable resource in generating future revenues. Patents, copyrights, and franchises are examples. They are reported in the balance sheet net of accumulated amortization. Some companies include intangible assets as part of property, plant, and equipment, while others report them either in a separate intangible asset classification or as other noncurrent assets.
Quite often, much of the value of intangibles is not reported in the balance sheet. For example, it would not be unusual for the historical cost of a patent to be significantly lower than its market value. As we discuss in Chapter 10, for internally developed intangibles, the costs that are included as part of historical cost are limited. Specifically, none of the research and development costs incurred in developing the intangible are included in cost.
Intangible assets generally represent exclusive rights that a company can use to generate future revenues.
OTHER ASSETS. Balance sheets often include a catch-all classification of noncurrent assets called other assets. This classification includes long-term prepaid expenses, called deferred charges, and any noncurrent asset not falling in one of the other classifications. For instance, if a company's noncurrent investments are not material in amount, they might be reported in the other asset classification rather than in a separate investments category.
Graphic 3-6 reproduces the noncurrent asset section of Dell Inc.'s 2009 and 2008 balance sheets. For Dell, noncurrent assets include property, plant, and equipment, investments, long-term financing receivables, goodwill (an intangible asset), purchased intangible assets, and other noncurrent assets.
Noncurrent Assets—Dell Inc.
Real World Financials
We've seen how assets are grouped into current and noncurrent categories and that noncurrent assets always are subclassified further. Let's now turn our attention to liabilities. These, too, are separated into current and noncurrent (long-term) categories.
Liabilities represent obligations to other entities. The information value of reporting these amounts is enhanced by classifying them as current liabilities and long-term liabilities. Graphic 3-7 shows the liability section of Dell Inc.'s 2009 and 2008 balance sheets.
Real World Financials
CURRENT LIABILITIES. Current liabilities are those obligations that are expected to be satisfied through the use of current assets or the creation of other current liabilities. So, this classification includes all liabilities that are expected to be satisfied within one year or the operating cycle, whichever is longer. An exception is a liability that management intends to refinance on a long-term basis. For example, if management intends to refinance a six-month note payable by substituting a two-year note payable and has the ability to do so, then the liability would not be classified as current even though it's due within the coming year. This exception is discussed in more detail in Chapter 13.
The most common current liabilities are accounts payable, notes payable (short-term borrowings), unearned revenues, accrued liabilities, and the currently maturing portion of long-term debt. Accounts payable obligations to suppliers of merchandise or of services purchased on open account. are obligations to suppliers of merchandise or of services purchased on open account, with payment usually due in 30 to 60 days. Notes payable promissory note (essentially an IOU) that obligates the issuing corporation to repay a stated amount at or by a specifi ed maturity date and to pay interest to the lender between the issue date and maturity. are written promises to pay cash at some future date (I.O.U.s). Unlike accounts payable, notes usually require the payment of explicit interest in addition to the original obligation amount. Notes maturing in the next year or operating cycle, whichever is longer, will be classified as current liabilities. Unearned revenues cash received from a customer in one period for goods or services that are to be provided in a future period., sometimes called deferred revenues as in Dell's balance sheet, represent cash received from a customer for goods or services to be provided in a future period.
Current liabilities are expected to be satisfied within one year or the operating cycle, whichever is longer.
Current liabilities usually include accounts and notes payable, unearned revenues, accrued liabilities, and the current maturities of long-term debt.
Accrued liabilities expenses already incurred but not yet paid (accrued expenses). represent obligations created when expenses have been incurred but will not be paid until a subsequent reporting period. Examples are accrued salaries payable, accrued interest payable, and accrued taxes payable. Dell Inc.'s accrued liabilities include accrued warranty liabilities, accrued income taxes, accrued compensation, and other.
Long-term notes, loans, mortgages, and bonds payable usually are reclassified and reported as current liabilities as they become payable within the next year (or operating cycle if that's longer).4 Likewise, when long-term debt is payable in installments, the installment payable currently is reported as a current liability. For example, a $1,000,000 note payable requiring $100,000 in principal payments to be made in each of the next 10 years is classified as a $100,000 current liability—current maturities of long-term debt the current installment due on long-term debt, reported as a current liability.—and a $900,000 long-term liability.
Chapter 13 provides a more detailed analysis of current liabilities.
Current liabilities include the current maturities of long-term debt.
LONG-TERM LIABILITIES. Long-term liabilities are obligations that will not be satisfied in the next year or operating cycle, whichever is longer. They do not require the use of current assets or the creation of current liabilities for payment. Examples are long-term notes, bonds, pension obligations, and lease obligations.
But simply classifying a liability as long-term doesn't provide complete information to external users. For instance, long-term could mean anything from 2 to 20, 30, or 40 years. Payment terms, interest rates, and other details needed to assess the impact of these obligations on future cash flows and long-term solvency are reported in a disclosure note.
Noncurrent, or longterm liabilities, usually are those payable beyond the current year.
Dell Inc. reports long-term debt, long-term deferred service revenue, and other noncurrent liabilities at the end of its 2009 fiscal year. A disclosure note indicates that other noncurrent liabilities include warranty liabilities, income taxes payable, and other. Long-term liabilities are discussed in subsequent chapters.
Recall from our discussions in Chapters 1 and 2 that owners' equity is simply a residual amount derived by subtracting liabilities from assets. For that reason, it's sometimes referred to as net assets. Also recall that owners of a corporation are its shareholders, so owners' equity for a corporation is referred to as shareholders' equity or stockholders' equity. Shareholders' equity for a corporation arises primarily from two sources: (1) amounts invested by shareholders in the corporation, and (2) amounts earned by the corporation (on behalf of its shareholders). These are reported as (1) paid-in capital invested capital consisting primarily of amounts invested by shareholders when they purchase shares of stock from the corporation. and (2) retained earnings amounts earned by the corporation on behalf of its shareholders and not (yet) distributed to them as dividends.. Retained earnings represents the accumulated net income earned since the inception of the corporation and not (yet) paid to shareholders as dividends.
Shareholders’ equity is composed of paid-in capital (invested capital) and retained earnings (earned capital).
Graphic 3-8 presents the shareholders' equity section of Dell Inc.'s 2009 and 2008 fiscal year-end balance sheets.
Shareholders' Equity—Dell Inc.
Real World Financials
From the inception of the corporation through January 30, 2009, Dell has accumulated net income, less dividends, of $20,677 million which is reported as retained earnings. The company's paid-in capital is represented by common stock and additional paid-in capital which collectively represent cash invested by shareholders in exchange for ownership interests. Information about the number of shares the company has authorized and how many shares have been issued also must be disclosed.
In addition to paid-in capital and retained earnings, shareholders' equity may include a few other equity components. For example, Dell reports accumulated other comprehensive income (loss). Accumulated other comprehensive income is discussed in Chapters 4, 12, and 18. Other equity components are addressed in later chapters, Chapter 18 in particular. We also discuss the concept of par value in Chapter 18.
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Balance Sheet Presentation. There are more similarities than differences in balance sheets prepared according to U.S. GAAP and those prepared applying IFRS. Some of the differences are:
International standards specify a minimum list of items to be presented in the balance sheet. U.S. GAAP has no minimum requirements.
| ||IAS No.1, revised,5 changed the title of the balance sheet to statement of financial position, although companies are not required to use that title. Some U.S. companies use the statement of financial position title as well.
|| || (K)|
Real World Financials
Under U.S. GAAP, we present current assets and liabilities before noncurrent assets and liabilities. IAS No. 1 doesn't prescribe the format of the balance sheet, but balance sheets prepared using IFRS often report noncurrent items first. For example, the balance sheet of Sanofi-Aventis, a French pharmaceutical company, included in a recent half-year report, presented assets, liabilities, and equity in the following order:
The FASB and IASB are working together on a project, Financial Statement Presentation, to establish a common standard for presenting information in the financial statements, including classifying and displaying line items and aggregating line items into subtotals and totals. This standard will have a dramatic impact on the format of financial statements. An important part of the proposal involves the organization of elements of the balance sheet (statement of financial position), statement of comprehensive income (including the income statement), and statement of cash flows into a common set of classifications.
Each of the financial statements will include classifications by operating, investing, and financing activities, providing a “cohesive” financial picture that stresses the relationships among the financial statements. Recall from your previous accounting education and from our brief discussion in Chapter 2, that this is the way we currently classify activities in the statement of cash flows.
For each statement, though, operating and investing activities will be included within a new category, “business” activities. Each statement also will include three additional groupings: discontinued operations, income taxes, and equity (if needed). The new look for the balance sheet (statement of financial position) will be:
The project has multiple phases and is not scheduled for completion until 2011.
The FASB and IASB are working together on a standard that would have a dramatic impact on the format of financial statements.
Demonstrating the cohesiveness among the financial statements is a key objective of the Financial Statement Presentation project.
BALANCE SHEET CLASSIFICATION
The following is a post-closing trial balance for the Sepia Paint Corporation at December 31, 2011, the end of the company's fiscal year:
The $50,000 balance in the investment account consists of marketable equity securities of other corporations. The company's intention is to hold the securities for at least three years. The $100,000 note payable is an installment loan. $10,000 of the principal, plus interest, is due on each July 1 for the next 10 years. At the end of the year, 100,000 shares of common stock were issued and outstanding. The company has 500,000 shares of common stock authorized.
Prepare a classified balance sheet for the Sepia Paint Corporation at December 31, 2011.
The usefulness of the balance sheet, as well as the other financial statements, is significantly enhanced by financial statement disclosures. We now turn our attention to these disclosures.