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CHAPTER 5
Balance Sheet and Statement of Cash Flows
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics Questions
Brief Exercises Exercises Problems
Concepts for Analysis
- Disclosure principles, uses of the balance sheet, financial flexibility.
- Classification of items in the balance sheet and other financial statements.
- Preparation of balance sheet; issues of format, terminology, and valuation.
- Statement of cash flows.
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives Questions
Brief Exercises Exercises
Problems
Concepts for Analysis
- Explain the uses and limitations of a balance sheet.
- Identify the major classifications of the balance sheet.
CA5-2,
CA5-
- Prepare a classified balance sheet using the report and account formats.
CA5-1,
CA5-2,
CA5-3,
CA5-
- Identify the purpose and content of the statement of cash flows.
13 CA5-
- Prepare a basic statement of cash flows.
- Understand the usefulness of the statement of cash flows.
26, 27, 28 12, 16 15, 16, 18 6, 7 CA5-
- Determine which balance sheet information requires supplemental disclosure.
- Describe the major disclosure techniques for the balance sheet.
ANSWERS TO QUESTIONS
- 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.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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).
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Some situations in which estimates affect amounts reported in the balance sheet include: (a) allowance for doubtful accounts. (b) depreciable lives and estimated salvage values for plant and equipment. (c) warranty returns. (d) determining the amount of revenues that should be recorded as unearned.
When estimates are required, there is subjectivity in determining the amounts. Such subjectivity can impact the usefulness of the information by reducing the faithful representation of the measures, either because of bias or lack of verifiability.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
- An increase in inventories increases current assets, which is in the numerator of the current ratio. Therefore, inventory increases will increase the current ratio. In general, an increase in the current ratio indicates a company has better liquidity, since there are more current assets relative to current liabilities.
Note to instructors—When inventories increase faster than sales, this may not be a good signal about liquidity. That is, inventory can only be used to meet current obligations when it is sold (and converted to cash). That is why some analysts use a liquidity ratio—the acid-test ratio—that excludes inventories from current assets in the numerator.
LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Liquidity describes the amount of time that is expected to elapse until an asset is converted into cash or until a liability has to be paid. The ranking of the assets given in order of liquidity is: (1) (d) Short-term investments. (2) (e) Accounts receivable. (3) (b) Inventory. (4) (c) Buildings. (5) (a) Goodwill.
LO: 1, 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 5 (Continued)
- The major limitations of the balance sheet are: (a) The values stated are generally historical and not at fair value. (b) 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. (c) 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.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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.
LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
- Classification in financial statements helps users by grouping items with similar characteristics and separating items with different characteristics. Current assets are expected to be converted to cash within one year or the operating cycle, whichever is longer—property, plant and equipment will provide cash inflows over a longer period of time. Thus, separating long-term assets from current assets facilitates computation of useful ratios such as the current ratio.
LO: 2, 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Separate amounts should be reported for accounts receivable and notes receivable. The amounts should be reported gross, and an amount for the allowance for doubtful accounts should be deducted. The amount and nature of any nontrade receivables, and any amounts designated or pledged as collateral, should be clearly identified.
LO: 2, 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
- No. Available-for-sale securities should be reported as a current asset only if management expects to convert them into cash as needed within one year or the operating cycle, whichever is longer. If available-for-sale securities are not held with this expectation, they should be reported as long- term investments.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The relationship between current assets and current liabilities is that current liabilities are those obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The total selling price of the season tickets is $20,000,000 (10,000 X $2,000). Of this amount, $8,000,000 has been earned by 12/31/17 (16/40 X $20,000,000). The remaining $12,000, should be reported as unearned revenue, a current liability in the 12/31/17 balance sheet (24/40 X $20,000,000).
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
Questions Chapter 5 (Continued)
- Battle is incorrect. Retained earnings is a source of assets, but is not an asset itself. For example, even though the funds obtained from issuing a note payable are invested in the business, the note payable is not reported as an asset. It is a source of assets, but it is reported as a liability because the company has an obligation to repay the note in the future. Similarly, even though the earnings are invested in the business, retained earnings is not reported as an asset. It is reported as part of shareholders’ equity because it is, in effect, an investment by owners which increases the ownership interest in the assets of an entity.
LO: 2, Bloom: C, M Difficulty: oderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The notes should appear as long-term liabilities with full disclosure as to their terms. Each year, as the profit is determined, notes of an amount equal to two-thirds of the year’s profits should be transferred from the long-term liabilities to current liabilities until all of the notes have been liquidated.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The difference between these two amounts may be due to increases in current assets (e.g., an increase in accounts receivable from a sale on account would result in an increase in revenue and net income but have no effect yet on cash). Similarly a cash payment that results in a decrease in an existing current liability (e.g., accounts payable would decrease cash provided by operations without affecting net income).
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The difference between these two amounts could be due to noncash charges that appear in the income statement. Examples of noncash charges are depreciation, depletion, and amortization of intangibles. Expenses recorded but unpaid (e.g., increase in accounts payable) and collection of previously recorded sales on credit (i.e., now decreasing accounts receivable) also would cause cash provided by operating activities to exceed net income.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 5 (Continued)
- (a) Net income is adjusted downward by deducting $5,000 from $90,000 and reporting cash provided by operating activities as $85,000.
(b) The issuance of the preferred stock is a financing activity. The issuance is reported as follows: Cash flows from financing activities Issuance of preferred stock............................................................. $1,150,
(c) Net income is adjusted as follows: Cash flows from operating activities Net income .......................................................................................... $90, Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ..................................................................... 14, Bond premium amortization ............................................................ (5,000) Net cash provided by operating activities ............................................. $99,
(d) The increase of $20,000 reflects an investing activity. The increase in Land is reported as follows: Cash flows from investing activities: Purchase Land ($ 10,000 - $ 30,000) ............................................. $(20,000)
LO: 5, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The company appears to have good liquidity and reasonable financial flexibility. Its current cash
debt coverage is 1.
, which indicates that it can pay off its current liabilities in a
given year from its operations. In addition, its cash debt coverage is also good at
, which indicates that it can pay off approximately 80% of its debt out of current
operations.
LO: 4, 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Free cash flow = $860,000 – $75,000 – $30,000 = $755,000.
LO: 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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.
LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 5-
Current assets
Cash ................................................................... $ 30,
Accounts receivable ......................................... $110,
Less: Allowance for doubtful accounts ..... 8,000 102,
Inventory ............................................................ 290,
Prepaid insurance ............................................. 9,
Total current assets .............................. $431,
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 5-
Current assets
Cash ................................................................... $ 7,
Equity Investments (Trading) ........................... 11,
Accounts receivable ......................................... $90,
Less: Allowance for doubtful accounts ..... 4,000 86,
Inventory ............................................................ 30,
Prepaid insurance ............................................. 5,
Total current assets .............................. $139,
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 5-
Long-term investments
Debt investments .............................................. $ 56,
Land held for investment .................................. 39,
Note receivables (long-term) ............................ 42,
Total investments ........................................ $137,
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Property, plant, and equipment
- BRIEF EXERCISE 5-
- Land $ 71,
- Buildings $207,
- Less: Accumulated depreciation 45,000 162,
- Equipment $190, - Less: Accumulated depreciation 19,000 171,
- Timberland 70, - Total property, plant, and equipment $474,
- BRIEF EXERCISE 5- LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
- Goodwill............................................................. $150, Intangible assets
- Patents 220,
- Franchises 130, - Total intangible assets................................ $500,
- BRIEF EXERCISE 5- LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
- Goodwill............................................................. $ 50, Intangible assets
- Franchises 47,
- Patents 33,
- Trademarks 10, - Total intangible assets................................ $140,
- BRIEF EXERCISE 5- LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
- Notes payable.................................................... $ 22, Current liabilities
- Accounts payable 72,
- Salaries and wages payable 4,
- Income taxes payable 7, - Total current liabilities $105,
BRIEF EXERCISE 5-
Stockholders’ equity
Preferred stock.................................................. $152,
Common stock .................................................. 55,
Additional paid-in capital ................................. 174,
Retained earnings ............................................. 114,
Stockholders’ equity – Stowe Company ......... 495,
Noncontrolling interest..................................... 63,
Total stockholders’ equity .......................... $558,
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 5-
Cash Flow Statement
Operating Activities
Net income .......................................................... $40,
Depreciation expense ........................................ $ 4,
Increase in accounts receivable ........................ (10,000)
Increase in accounts payable ............................ 7,000 1,
Net cash provided by operating activities ...... 41,
Investing Activities
Purchase of equipment ...................................... (8,000)
Financing Activities
Issue notes payable ........................................... $20,
Dividends paid .................................................... (5,000)
Net cash flow from financing activities....... 15,
Net increase in cash ($41,000 – $8,000 + $15,000)..... $48,
Free Cash Flow = $41,000 (Net cash provided by operating activities) –
$8,000 (Purchase of equipment) – $5,000 (Dividends) = $28,000.
LO: 5, 6, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 5-
Cash flows from operating activities
Net income .......................................................... $151,
Adjustments to reconcile net income to
net cash provided by operating activities
Depreciation expense ................................... $44,
Increase in accounts payable ...................... 9,
Increase in accounts receivable .................. (13,000) 40,
Net cash provided by operating activities ........ $191,
LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 5-
Sale of land and building ......................................... $191,
Purchase of land ...................................................... (37,000)
Purchase of equipment ............................................ (53,000)
Net cash provided by investing activities ......... $101,
LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 5-
Issuance of common stock...................................... $147,
Purchase of treasury stock...................................... (40,000)
Payment of cash dividend ....................................... (95,000)
Retirement of bonds................................................. (100,000)
Net cash used by financing activities ............... $ (88,000)
LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 5-
Free Cash Flow Analysis
Net cash provided by operating activities .............. $400,
Purchase of equipment................................ (53,000)
Purchase of land* ......................................... (37,000)
Dividends ...................................................... (95,000)
Free cash flow .......................................................... $215,
*If the land were purchased as an investment, it would be excluded in the
computation of free cash flow.
LO: 6, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 5-1 (Continued)
(j) Current asset, if expect to trade within one year.
(k) Current liability.
(l) Current liability.
(m) Current asset (inventory).
(n) Current liability.
LO: 2, 3, Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: AICPA BB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
EXERCISE 5-2 (15–20 minutes)
1. (h) 11. (b)
2. (d) 12. (f)
3. (f) 13. (a)
4. (f) 14. (h)
5 (c) 15. (c)
6. (a) 16. (b)
7. (f) 17. (a)
8. (g) 18. (a)
9. (a) 19. (g)
10. (a) 20. (f)
LO: 2, 3, Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: AICPA BB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 5-3 (15–20 minutes)
1. (a) 10. (f)
2. (b) 11. (a)
3. (f) 12. (f)
4. (a) 13. (a) or (e) (preferably (a))
5 (f) 14. (c) and (n)
6. (h) 15. (f)
7. (j) 16. (x)
8. (d) 17. (f)
9. (a) 18. (c)
19. (i)
LO: 2, 3, Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: AICPA BB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 5-4 (Continued)
Liabilities and Stockholders’ Equity
Current liabilities
Salaries and wages payable ........................... $XXX
Notes payable, short-term .............................. XXX
Unearned subscriptions revenue ................... XXX
Unearned rent revenue ................................... XXX
Total current liabilities .............................. $XXX
Long-term debt
Bonds payable, due in four years .................. $XXX
Less: Discount on bonds payable.................. XXX XXX
Total liabilities ........................................... XXX
Stockholders’ equity
Capital stock:
Common stock .......................................... XXX
Additional paid-in capital:
Paid-in capital in excess of par
(common stock) ....................................... XXX
Total paid-in capital ............................. XXX
Retained earnings ........................................... XXX
Total paid-in capital and
retained earnings .............................. XXX
Less: Treasury stock, at cost .................. (XXX)
Equity attributable to Denis Savard, Inc. ....... XXX
Equity attributed to noncontrolling interest .. XXX
Total stockholders’ equity .................. XXX
Total liabilities and
stockholders’ equity ......................... $XXX
Note to instructor: An assumption made here is that cash included the
restricted cash for plant expansion. If it did not, then a subtraction from
cash would not be necessary or the cash balance would be “grossed up”
and then the restricted cash for plant expansion deducted.
LO: 2, 3, Bloom: AP, Difficulty: Simple, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 5-5 (30–35 minutes)
Uhura Company
Balance Sheet
December 31, 2017
Assets
Current assets
Cash ........................................................ $230,
Equity investments (trading) ................. 120,
Accounts receivable ............................... $357,
Less: Allowance for doubtful
accounts ......................................... 17,000 340,
Inventory, at lower-of-average
cost-or-market ..................................... 401,
Prepaid expenses ................................... 12,
Total current assets.......................... $1,103,
Long-term investments
Land held for future use......................... 175,
Cash surrender value of life
insurance ............................................. 90,000 265,
Property, plant, and equipment
Buildings ................................................. $730,
Less: Accum. depr.—buildings ....... 160,000 570,
Equipment ............................................... 265,
Less: Accum. depr.—equipment ..... 105,000 160,000 730,
Intangible assets
Goodwill .................................................. 80,
Total assets ...................................... $2,178,
