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Copyright 2004 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
PowerPoint Presentation Materials
For
Financial Accounting:
A New Perspective
by
Dr. Joseph Otto
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CLASSIFIED BALANCE SHEET
Classifies assets, liabilities into current and noncurrent categoriesCurrent categoriesAccounts expected to be
Turned into cashSoldExchangedDischarged
Within one year
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CMUBalance Sheet
12/31Assets
Current assets
Investments
Property, plant,
Equipment
$56,300
2,000
16,700
Liabilities
Current
Noncurrent
Owner’s Equity
$9,000
4,000
61,900
Total assets $75,000
Total liabilities & Equity $75,000
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WHY DISTINGUISH BETWEEN CURRENT, NONCURRENT?
To allocate resources to meet needs
Timing influences decisions
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HOW TO DISTINGUISH BETWEEN CURRENT, NONCURRENT
Operating cycle
Related to current assets, liabilitiesAverage length of time it takes to move
through 3 phasesPurchasingSellingCollecting
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CURRENT ASSETS
Current assets areCashNoncash assets that will be
Converted into cashSoldConsumed
Within 1 year or operating cycle, whichever is longer
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LIQUIDITY
Measure of availability of cashHow quickly noncash assets can be
turned into cash
Sign of financial health
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CURRENT LIABILITIES
Current liabilities areObligations that will be eliminated
within one year or operating cycle of business
Paid byCurrent assetsCreating other current liabilities
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USING BALANCE SHEET RATIOS
RatiosShow percentage relationship
between 2 numbersSummarize informationEasily understood, interpreted,
compared
Example: Return on equityMeasures performance
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HOW TO USE LIQUIDITY RATIOS
Help determine solvencyAbility to meet obligations that
come due in current period
Working capitalCurrent assets – Current liabilitiesLimitation: measures absolute
ability to meet debts
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CURRENT RATIO
Measures relative ability to meet maturing current debts (solvency)
High ratio desirable
Current Asset
Current Liabilities
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ACID TEST RATIO
Measures relative ability to meet maturing current debts (solvency)
High ratio desirable
Current assets – (Inventories + prepaid Assets)
Current Liabilities
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BANK RATIOSApproving Susan’s Loan
Banker’s measure of loan risk
To protect lenderLoan to valueLoan to liquidation value
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DEBT TO ASSETS RATIO
Indicates long-run solvency of business
Describes relative amount of financial risk
Total Liabilities
Total Assets
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DEBT TO EQUITY RATIO
Indicates long-run solvency of business
Describes relative amount of financial risk
Total Liabilities
Total Owners’ Equity
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Discussions of Liquidity, Leverage
Contained in Annual ReportManagement’s Discussion &
Analysis (MD&A)Provides liquidity, leverage ratiosProvides discussion/interpretation of
ratios
Example: Merck
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USING INFORMATION TO MAKE DECISIONS: MD&A
Outside balance sheet
Management’s Discussion and Analysis of Operations (MD&A)Relates to balance sheetLiquidity and Capital Resources
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USING INFORMATION TO MAKE DECISIONS:
Information that documents, supports, elaborates on specific items
Summary of significant accounting policiesEssential accounting principles of
business
Other notesDetail for balance sheet accounts
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USING INFORMATION TO MAKE DECISIONS:
CommitmentsExecutory contractExample: noncancelable lease
arrangements
ContingencyMay never materializePotential future obligation
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Executory Contract
Promise to perform duties in future
Commitment
No current liability
Definition: liabilityProbably future sacrifices of economic
benefits arising from present obligations
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HOW ARE ASSETS MEASURED?
Entry prices Historical cost Current cost
Exit prices Fair market value (FMV) Present value of future cash flows
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When are Valuation Methods Equivalent?
At point of exchange when recordedHistorical costs = current cost = fair
market value (FMV) = present value of future cash flows
Valuation methods differ when reported
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ASSET VALUATION
Personal balance sheetEstimated current value or fair market
value (FMV)
Business balance sheetFollows GAAP
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ASSET VALUATION:Current Assets
Asset
Category
Account Measurement
Current Cash
Marketable Sec.
A/R
Inventory
Monetary
FMV or cost
FMV less
allowance
LCM
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ASSET VALUATION:Investments
Asset
Category
Account Measurement
Investments Equity
Bonds
Long term
Notes
Receivables
FMV
Present value of future cash
flows
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ASSET VALUATION:Property, Plant, Equipment
Asset
Category
Account Measurement
Property, Plant, Equipment
Buildings, Equipment, etc.
Cost less Accumulated Depreciation
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ASSET VALUATION:Intangible Assets
Asset
Category
Account Measurement
Intangibles Patents, Goodwill, etc
Cost less Amortization
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KEY QUALITATIVE CHARACTERISTICS
Characteristics of accounting informationRelevance
Makes a difference in a decisionReliability
Degree of confidence in informationVerifiability
Traceable
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Limitations of Balance Sheet
Not all obligations reported in liabilitiesAsset valuation not always current market valueQualitative information incompleteMoney measurement assumes stable dollar; no inflationHuman resources not reported, valued