(25) Understanding Balance Sheets

Question 1

LOS 25. a: Describe the elements of the balance sheet: assets, liabilities, and equity.

Answer 1

Assets are resources controlled as result of past transactions that are expected to provide future economic benefits.

Question 2

LOS 25. a: Describe the elements of the balance sheet: assets, liabilities, and equity.

Answer 2

Liabilities are obligations as a result of past events that are expected to require an outflow of economic resources.

Question 3

LOS 25. a: Describe the elements of the balance sheet: assets, liabilities, and equity.

Answer 3

Equity is the owners’ residual interest in the assets after deducting the liabilities.

Question 4

LOS 25. a: Describe the elements of the balance sheet: assets, liabilities, and equity. When should a financial statement item be recognized?

Answer 4

A financial statement item should be recognized if a future economic benefit to or from the firm is probable and the item’s value or cost can be measured reliably.

Question 5

LOS 25. b: Describe uses and limitations of the balance sheet in financial analysis.

Answer 5

The balance sheet can be used to assess a firm’s liquidity, solvency, and ability to pay dividends to shareholders.

Question 6

LOS 25. b: Describe uses and limitations of the balance sheet in financial analysis. How should we measure balance sheet items value?

Answer 6

Balance sheet assets, liabilities, and equity should not be interpreted as market value or intrinsic value. For most firms, the balance sheet consists of a mixture of values including historical cost, amortized cost, and fair value.

Question 7

LOS 25. b: Describe uses and limitations of the balance sheet in financial analysis.

Answer 7

Some assets and liabilities are difficult to quantify and are not reported on the balance sheet.

Question 8

LOS 25. b: Describe uses and limitations of the balance sheet in financial analysis. Which financial assets should be listed at historical cost, amortized cost, and fair value?

Answer 8

Question 9

LOS 25. c: Describe alternative formats of balance sheet presentations.

Answer 9

A classified balance sheet separately reports current and noncurrent assets and current and noncurrent liabilities. Alternatively, liquidity-based presentations, often used in the banking industry, present assets and liabilities in order of liquidity.

Question 10

LOS 25. d: Distinguish between current and non-current assets and current and non-current liabilities.

Answer 10

Current (noncurrent) assets are those expected to be used up or converted to cash in less than (more than) one year or the firm’s operating cycle, whichever is greater.

Question 11

LOS 25. d: Distinguish between current and non-current assets and current and non-current liabilities.

Answer 11

Current (noncurrent) liabilities are those the firm expects to satisfy in less than (more than) one year or the firm’s operating cycle, whichever is greater.

Question 12

LOS 25. e: Describe different types of assets and liabilities and the measurement bases of each. Cash equivalents

Answer 12

Cash equivalents are short-term, highly liquid financial assets that are readily convertible to cash. Their balance sheet values are generally close to identical, using either amortized cost or fair value.

Question 13

LOS 25. e: Describe different types of assets and liabilities and the measurement bases of each. Accounts receivable

Answer 13

Accounts receivable are reported at net realizable value by estimating bad debt expense.

Question 14

LOS 25. e: Describe different types of assets and liabilities and the measurement bases of each. Inventories

Answer 14

Inventories are reported at the lower of cost or net realizable value (IFRS) or the lower of cost or market (U.S. GAAP). Cost can be measured using standard costing or the retail method. Different cost flow assumptions can affect inventory values.

Question 15

LOS 25. e: Describe different types of assets and liabilities and the measurement bases of each. Property, plant, and equipment (PP&E)

Answer 15

Property, plant, and equipment (PP&E) can be reported using the cost model or the revaluation model under IFRS. Under U.S. GAAP, only the cost model is allowed. PP&E is impaired if its carrying value exceeds the recoverable amount. Recoveries of impairment losses are allowed under IFRS but not U.S. GAAP.

Question 16

LOS 25. e: Describe different types of assets and liabilities and the measurement bases of each. Intangible assets

Answer 16

Intangible assets created internally are expensed as incurred. Purchased intangibles are reported similar to PP&E. Under IFRS, research costs are expensed as incurred and development costs are capitalized. Both research and development costs are expensed under U.S. GAAP.

Question 17

LOS 25. e: Describe different types of assets and liabilities and the measurement bases of each. Goodwill

Answer 17

Goodwill is the excess of purchase price over the fair value of the identifiable net assets (assets minus liabilities) acquired in a business acquisition. Goodwill is not amortized but must be tested for impairment at least annually.

Question 18

LOS 25. e: Describe different types of assets and liabilities and the measurement bases of each. Held-to-maturity securities, trading securities, available-for-sale securities, and derivatives.

Answer 18

Held-to-maturity securities are reported at amortized cost. Trading securities, available-for-sale securities, and derivatives are reported at fair value. For trading securities and derivatives, unrealized gains and losses are recognized in the income statement. Unrealized gains and losses for available-for-sale securities are reported in equity (other comprehensive income).

Question 19

LOS 25. e: Describe different types of assets and liabilities and the measurement bases of each. Accounts payable and accrued liabilities

Answer 19

Accounts payable are amounts owed to suppliers for goods or services purchased on credit. Accrued liabilities are expenses that have been recognized in the income statement but are not yet contractually due. Unrealized revenue is cash collected in advance of providing goods and services.

Question 20

LOS 25. e: Describe different types of assets and liabilities and the measurement bases of each. Financial liabilities

Answer 20

Financial liabilities are issued at face value, like bonds payable, are reported at amortized cost. Held-for-trading liabilities and derivative liabilities are reported at fair value.

Question 21

LOS 25. f: Describe the components of shareholders’ equity.

Answer 21

Owners’ equity includes:

Contributed capital

Preferred stock

Treasury stock

Retained earings

Noncontrolling (minority) interest

Accumulated other comprehensive income

Question 22

LOS 25. f: Describe the components of shareholders’ equity. Define contributed capital.

Answer 22

Contributed capital – the amount paid in by common shareholders

Question 23

LOS 25. f: Describe the components of shareholders’ equity. Define preferred stock.

Answer 23

Preferred stock – capital that has certain rights and privileges not possessed by the common shareholders. Classified as debt if mandatorily redeemable.

Question 24

LOS 25. f: Describe the components of shareholders’ equity. Define treasury stock.

Answer 24

Treasury stock – issued common stock that has been repurchased by the firm.

Question 25

LOS 25. f: Describe the components of shareholders’ equity. Retained earnings.

Answer 25

Retained earnings – the cumulative undistributed earnings of the firm since inception.

Question 26

LOS 25. f: Describe the components of shareholders’ equity. Define noncontrolling (minority) interest.

Answer 26

Noncontrolling (minority) interest – the portion of a subsidiary that is not owned by the parent

Question 27

LOS 25. f: Describe the components of shareholders’ equity. Define accumulated other comprehensive income.

Answer 27

Accumulated other comprehensive income – includes all changes to equity from sources other than net income and transactions with shareholders.

Question 28

LOS 25. f: Describe the components of shareholders’ equity. Define statement of changes in stockholders’ equity.

Answer 28

The statement of changes in stockholders’ equity summarizes the transactions during a period that increases or decrease equity, including transactions with shareholders.

Question 29

LOS 25. g: Convert balance sheets to common-size balance sheets and interpret common-size balance sheets.

Answer 29

A vertical common-size balance sheet expresses each item of the balance sheet as a percentage of total assets. The common-size format standardizes the balance sheet by eliminating the effects of size. This allows for comparison over time (time-series analysis) and across firms (cross-sectional analysis).

Question 30

LOS 25. h: Calculate and interpret liquidity and solvency ratios.

Answer 30

Balance sheet ratios, along with common-size analysis, can be used to evaluate a firm’s liquidity and solvency.

Liquidity ratios measure the firm’s ability to satisfy its short-term obligations as they come due.

Liquidity ratios include:

the current ratio

the quick ratio

the cash ratio

Question 31

LOS 25. h: Calculate and interpret liquidity and solvency ratios.

Answer 31

Balance sheet ratios, along with common-size analysis, can be used to evaluate a firm’s liquidity and solvency.

Solvency ratios measure the firm’s ability to satisfy its long-term obligations.

Solvency ratios include:

the long-term debt-to-equity ratio

the total debt-to-equity ratio

the debt ratio

the financial leverage ratio