Chapter 3

| You Will Learn...

1. To describe the specific elements of the balance sheet (assets, liabilities, and owners’ equity), and prepare a balance sheet with assets and liabilities properly classified into current and noncurrent categories. Remember:

C A balance sheet is a listing of a company’s assets, liabilities, and equities as of a certain point in time.

C For balance sheet reporting, assets and liabilities are often separated into current and noncurrent categories.

C When classifying assets and liabilities, the key considerations are how management intends to use an asset and when it expects to pay a liability.

C Equity arises from owner investment, is increased by net income and decreased by losses and by distributions to owners.

2. To identify the different formats used to present balance sheet data.

C In most industries, assets and liabilities are listed in order of their liquidity, with current items first.

C In other countries, the format of the balance sheet may vary widely.

3. To analyze a company’s performance and financial position through the computation of financial ratios. You should understand that:

C Balance sheet information is most often analyzed by looking at relationships between different balance sheet amounts and relationships between balance sheet and income statements amounts.

C Relationships between financial statement amounts are called financial ratios. Common financial ratios involving comparison of balance sheet amounts are current ratio, debt ratio, and asset mix ratios.

C Common financial ratios involving comparison of balance sheet and income statement amounts are asset turnover, return on assets, and return on equity.

4. To recognize the importance of the notes to the financial statements, and outline the types of disclosures made in the notes.

C Financial statement information is supported by explanatory notes.

· Common disclosures: (1) summary of significant accounting policies; (2) additional information to support summary totals; (3) information about items

that fail to meet the recognition criteria but are still considered to be significant; and (4) supplementary information.

C Note disclosure also sometimes relates to subsequent events.

5. To understand the major limitations of the balance sheet. They include:

C The balance sheet often does not provide an accurate reflection of the value of a business for various reasons, including (1) use of historical cost instead of current values; (2) omission of some assets from the balance sheet; and/or (3) failure to make adjustments for inflation.

C The balance sheet does not measure the market value of a company.

| Important Points

Usefulness of the Balance Sheet

The usefulness of the balance sheet is often underestimated. Some believe that the income statement is the only important financial statement and that the balance sheet is only a statement of residuals. The balance sheet is important in assessing liquidity and solvency, especially in a time when so many companies have experienced financial difficulty. Also, the book value of net assets is often compared to the market valuation of outstanding stock as a measure of investment value.

Alternative Valuation Bases for Assets

To reinforce your perspective of GAAP valuation methods, contrast balance sheet valuation bases for profit-seeking entities with those for personal financial statements, i.e., estimated current value valuation. Identify advantages and disadvantages of using current value instead of historical cost.