Ch. 5 - Balance Sheet Flashcards
- What is meant by solvency? What information in the balance sheet can be used to assess a company’s solvency?
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).
- A recent financial magazine indicated that the airline industry has poor financial flexibility. What is meant by financial flexibility, and why is it important?
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. 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.
- How does information from the balance sheet help users of the financial statements?
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.
- What are the major limitations of the balance sheet as a source of information?
- The values stated are generally historical and not at fair value.
- 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.
- 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.
- Discuss at least two items that are important to the value of companies like Intel or IBM but that are not recorded in their balance sheets. What are some reasons why these items are not recorded in the balance sheet?
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.g., 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.
- What is working capital? How does working capital relate to the operating cycle?
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.
- Where should all of the following be shown on a classified balance sheet?
- Sinking fund
- Unamortized premium on bonds payable
- Merchandise held on consignment
- Land
- Merchandise out on consignment
- Long-T erm Investments. “Sinking fund
-Long-term debt (adjunct account to bonds payable). “Unamortized premium on bonds payable
-Merchandise held on consignment should not appear on the consignee’s balance sheet
except possibly as a note to the financial statements.
-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 inventory
- State the generally accepted accounting principle appli- cable to balance sheet valuation of each of the following assets.
(a) Trade accounts receivable.
(b) Land.
(c) Inventories.
(d) Trading securities (common stock of other companies). (e) Prepaid expenses.
(a) 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
(b) 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.
(e) Prepaid expenses should be stated at cost less the amount apportioned to and written off
over the previous accounting periods.
- Whatisthepurposeofastatementofcashflows?Howdoes it differ from a balance sheet and an income statement?
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.
- Differentiate between operating activities, investing ac- tivities, and financing activities
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 long-term liability and stockholders’ 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
- What is the purpose of a free cash flow analysis?
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
- What are some of the techniques of disclosure for the balance sheet?
Some of the techniques of disclosure for the balance sheet are: (a) Parenthetical explanations.
(b) Notes to the financial statements.
(c) Cross references and contra items.
(d) Supporting schedules.
- What is a “Summary of Significant Accounting Policies”?
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
- What types of contractual obligations must be disclosed in great detail in the notes to the balance sheet? Why do you think these detailed provisions should be disclosed?
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.
1a. Identify the major classifications of the balance sheet
The general ele- ments of the balance sheet are assets, liabilities, and equity. The major classifications of assets are current assets; long-term investments; property, plant, and equipment; intan- gible assets; and other assets. The major classifications of liabilities are current and long- term liabilities. The balance sheet of a corporation generally classifies owners’ equity as capital stock, additional paid-in capital, and retained earnings.
