Admas University

Kality Campus
Department of Accounting and
finance

Course title: Intermediate financial

accounting I
Course code: Acfn 3031
Credit hours: 4
Learning Objectives
After studying this chapter, you should be able to:
1. Explain the uses, limitations, and content of the
sstatement of financial position
2. Prepare a classified sstatement of financial position
3. Explain the purpose, content, and presentation of the
statement of cash flows.
4. Describe additional types of information provided.

2
Preview of Chapter 3
Statement of financial position and Statement of Cash Flows

Statement of financial position

1. Usefulness of the sstatement of financial position
2. Limitations of the sstatement of financial position
3. Classification in the sstatement of financial position

Preparation of Statement of financial position

• Account form
• Report form
3
Preview of Chapter 3
Hey, It Doesn’t Balance!
Statement of Cash Flows
• Purpose of the statement of cash flows
• Content of the statement of cash flows
• Preparation of the statement of cash flows
• Usefulness of the statement of cash flows
Additional Information
• Notes to the financial statements
• Techniques of disclosure
4
Learning Objective 1
Explain the Uses, Limitations, and Content
of the Statement of financial position

5
Statement of financial position (1 of 4)

Statement of financial position , sometimes referred to

as the balance sheet:
1. Reports assets, liabilities, and equity at a specific date.
2. Provides information about resources, obligations to
creditors, and equity in net resources.
3. Helps in predicting amounts, timing, and uncertainty of
future cash flows.

LO 1 6
Statement of financial Usefulnes (2 of 4)
Usefulness of the statement of financial position
• Computing rates of return
• Evaluating capital structure
• Assess risk and future cash flows
• Analyze the company’s:
• Liquidity
• Solvency
• Financial flexibility

LO 1 7
Statement of financial Limitatios(3 of 4)
Limitations of the Statement of financial position

1. Most assets and liabilities are reported at historical

cost
2. Use of judgments and estimates
3. Many items of financial value are omitted

LO 1 8
Statement of financial position (4 of 4)
Classification in the Balance Sheet

Elements of The Statement of financial position

1. Assets. Probable future economic benefits obtained or
controlled by a particular entity as a result of past
transactions or events.
2. Liabilities. Probable future sacrifices of economic benefits
arising from present obligations of a particular entity to
transfer assets or provide services to other entities in the
future as a result of past transactions or events.

LO 1 9
Classification in the Statement of financial position
Element of the statement of financial postion.

3. Equity. Residual interest in the assets of an entity that

remains after deducting its liabilities. In a business
enterprise, the equity is the ownership interest.

LO 1 10
Classification in the Statement of financial position
(1 of 2)

Assets Liabilities and Owners' Equity

Current assets Current liabilities
Long-term investments Long-term debt
Property, plant, and equipment Owners' (stockholders') equity
Intangible assets
Other assets

In practice you usually see little departure from these major

subdivisions.

LO 1 11
Classification in the Statement of financial position
(2 of 2)
Current Assets

Cash and other assets a company expects to convert into cash, sell, or
consume either in one year or in the operating cycle, whichever is
longer.
Item Basis of Valuation
Cash and cash equivalents Fair value
Short-term investments Generally, fair value
Receivables Estimated amount collectible
Inventories Lower-of-cost-or-net realizable value/market
Prepaid expenses Cost

LO 1 12
Current Assets
Cash
• Generally any monies available “on demand”
• Cash equivalents - short-term highly liquid investments that
mature within three months or less
• Restrictions or commitments must be disclosed

LO 1 13
Cash
Statement of financial position
Presentation

LO 1 14
Current Assets (1 of 2)
Short-Term Investments (Equity Securities)
All equity securities are recorded at fair value with
changes reported in net income unless:
• Accounted for under equity method or
• Not practicable to determine fair value

LO 1 15
Current Assets (2 of 2)
Short-Term Investments (Debt Securities)
Three separate classifications for debt securities:
Held-to-maturity: Company has positive intent and ability
to hold to maturity.
Trading: Bought and held primarily for sale in the near
term to generate income on short-term price differences.
Available-for-sale: Not classified as held-to-maturity or
trading securities.

LO 1 16
Short-Term Investments
Balance Sheet Presentation

LO 1 17
Current Assets
Receivables
Major categories of receivables should be shown in the
balance sheet or the related notes.
A company should clearly identify
• Anticipated loss due to uncollectibles
• Amount and nature of any nontrade receivables
• Receivables used as collateral

LO 1 18
Receivables
Statement of financial position
Presentation

LO 1 19
Current Assets
Inventories
Disclose
• Basis of valuation
• Lower-of-cost-or-net realizable value or
• Lower-of-cost-or-market
• Cost flow assumption (e.g., FIFO or LIFO)

LO 1 20
Inventories (1 of 2)
Statement of financial position Presentation
Acer Incorporated
(in thousands)
Current assets
Raw materials $ 442,706
Work in process 1,506
Finished goods 515,202
Spare parts 138,477
Inventories in transit 281,364
Less: Provision for inventory obsolescence
and net realizable value (159,553)
$1,219,702

Note 8 (in part): Inventories. Inventories are measured at the lower of standard cost and net
realizable value. The differences between standard and actual cost are fully recognized in cost of
sales. Net realizable value represents the estimated selling price in the ordinary course of business,
less all estimated costs of completion and necessary selling expenses.
LO 1 21
Inventories (2 of 2)
Statement of financial position
Presentation (Weyerhaeuser)

LO 1 22
Current Assets
Prepaid Expenses
Payment of cash, that is recorded as an asset because
service or benefit will be received in the future.
Cash Payment Before Expense Recorded
Prepayments often occur in regard to:
• insurance • rent
• supplies • taxes
• advertising

LO 1 23
Prepaid Expenses
Statement of financial position
Presentation

LO 1 24
Current Assets (1 of 2)
Illustration
BE5.2 Koch Corporation’s adjusted trial balance contained
the following asset accounts at December 31, 2020: Cash
$7,000, Land $40,000, Patents $12,500, Accounts
Receivable $90,000, Prepaid Insurance $5,200, Inventory
$30,000, Allowance for Doubtful Accounts $4,000, and
Equity Investments (to be sold in the next quarter) $11,000.
Prepare the current assets section of the balance sheet,
listing the accounts in proper sequence.

LO 1 25
Current Assets (2 of 2)
Illustration
BE5.2 Prepare the current assets section of the balance
sheet, listing the accounts in proper sequence.
Current assets
Cash $ 7,000
Equity investments 11,000
Accounts receivable $90,000
Less: Allowance for doubtful accounts 4,000 86,000
Inventory 30,000
Prepaid insurance 5,200
Total current assets $139,200

LO 1 26
Noncurrent Assets
Long-Term Investments
1. Securities (bonds, common stock, or long-term notes).
2. Tangible fixed assets not currently used in operations
(land held for speculation).
3. Special funds (sinking fund, pension fund, plant
expansion fund, or cash surrender value of life
insurance).
4. Nonconsolidated subsidiaries or affiliated companies.

LO 1 27
Long-Term Investments (1 of 4)
Usually presented on balance sheet below “Current
assets,” in a separate section called “Investments.”
• Debt investments classified as available-for-sale are
reported at fair value
• Held-to-maturity debt investments are reported at
amortized cost
• Equity investments are reported at fair value or by
using the equity method

LO 1 28
Long-Term Investments (2 of 4)
Statement of financial position
Presentation

LO 1 29
Long-Term Investments (3 of 4)
Illustration
BE5.3 Included in Outkast Company’s December 31, 2020,
trial balance are the following accounts: Prepaid Rent
$5,200, Debt Investments (to be held to maturity until
2023) $56,000, Unearned Fees $17,000, Land (held for
investment) $39,000, and Notes Receivable (long-term)
$42,000.
Prepare the long-term investments section of the balance
sheet.

LO 1 30
Long-Term Investments (4 of 4)
Illustration
BE5.3 Prepare the long-term investments section of the
balance sheet.
Long-term investments
Debt investments $ 56,000
Land held for investment 39,000
Note receivables (long-term) 42,000
Total investments $137,000

LO 1 31
Noncurrent Assets
Property, Plant, and Equipment
Tangible, long-lived assets used in the regular operations
of the business.
• Physical property such as land, buildings, machinery,
furniture, tools, and wasting resources (minerals).
• With the exception of land, a company either
depreciates (e.g., buildings) or depletes (e.g., oil
reserves) these assets.

LO 1 32
Property, Plant, and Equipment
Statement of financial position
Presentation

LO 1 33
Property, Plant, and Equipment (1 of 2)
Illustration
BE5.4 Lowell Company’s December 31, 2020, trial balance
includes the following accounts: Inventory $120,000,
Buildings $207,000, Accumulated Depreciation—
Equipment $19,000, Equipment $190,000, Land (held for
investment) $46,000, Accumulated Depreciation—
Buildings $45,000, Land $71,000, and Timberland $70,000.
Prepare the property, plant, and equipment section of the
balance sheet.

LO 1 34
Property, Plant, and Equipment (2 of 2)
Illustration

BE5.4 Prepare the property, plant, and equipment section

of the balance sheet.
Property, plant, and equipment
Land $ 71,000
Buildings $207,000
Less: Accumulated depreciation 45,000 162,000
Equipment 190,000
Less: Accumulated depreciation 19,000 171,000
Timberland 70,000
Total property, plant, and equipment $474,000

LO 1 35
Noncurrent Assets
Intangible Assets
Lack physical substance and are not financial instruments.
• Limited life intangibles amortized
• Indefinite-life intangibles tested for impairment

LO 1 36
Intangible Assets (1 of 3)
Statement of financial position
Presentation

LO 1 37
Intangible Assets (2 of 3)
Illustration
BE5.5 Crane Corporation has the following accounts
included in its December 31, 2020, trial balance: Equity
Investments (to be sold in the next 6 months) $21,000,
Goodwill $150,000, Prepaid Insurance $12,000, Patents
$220,000, and Franchises $130,000.
Prepare the intangible assets section of the balance
sheet.

LO 1 38
Intangible Assets (3 of 3)
Illustration
BE5.5 Prepare the intangible assets section of the balance
sheet.
Intangible assets
Goodwill $150,000
Patents 220,000
Franchises 130,000
Total intangible assets $500,000

LO 1 39
Noncurrent Assets
Other Assets
Items vary in practice. Can include

• Long-term prepaid • Deferred income taxes

expenses • Property held for sale
• Prepaid pension cost • Restricted cash or
• Noncurrent receivables securities
• Assets in special funds

LO 1 40
Classification in the Statement of financial position
Liabilities

Classified as current or long-term.

Current Liabilities
Obligations a company reasonably expects to liquidate
either through the use of current assets or the creation of
other current liabilities.

LO 1 41
Liabilities
Current Liabilities
1. Payables resulting from the acquisition of goods and
services: accounts payable, wages payable, taxes
payable, and so on.
2. Collections received in advance, such as unearned rent
revenue or unearned subscriptions revenue.
3. Other liabilities, such as the portion of long-term
bonds to be paid in the current period or short-term
obligations arising from the purchase of equipment.

LO 1 42
Current Liabilities (1 of 3)
Statement of financial position
Presentation

LO 1 43
Current Liabilities (2 of 3)
Illustration
BE5.8 Included in Adams Company’s December 31, 2020,
trial balance are the following accounts: Accounts Payable
$220,000, Pension Liability $375,000, Discount on Bonds
Payable $29,000, Unearned Rent Revenue $41,000, Bonds
Payable $400,000, Salaries and Wages Payable $27,000,
Interest Payable $12,000, and Income Taxes Payable
$29,000. Prepare the current liabilities section of the
balance sheet.

LO 1 44
Current Liabilities (3 of 3)
Illustration
BE5.8 Prepare the current liabilities section of the
balance sheet.
Current liabilities
Accounts payable $220,000
Unearned rent revenue 41,000
Salaries and wages payable 27,000
Interest payable 12,000
Income taxes payable 29,000
Total $329,000

LO 1 45
Liabilities
Long-Term Liabilities
Obligations that a company does not reasonably expect
to liquidate within the normal operating cycle.
Companies classify long-term liabilities that mature
within the current operating cycle as current liabilities if
payment of the obligation requires the use of current
assets.

LO 1 46
Long-Term Liabilities (1 of 4)
Three types:
1. Obligations arising from specific financing situations,
such as the issuance of bonds, long-term lease
obligations, and long-term notes payable.
2. Obligations arising from pension obligations and
deferred income tax liabilities.
3. Obligations that depend on the occurrence or non-
occurrence of one or more future events, such as
service or product warranties and other contingencies.

LO 1 47
Long-Term Liabilities (2 of 4)
Statement of financial position
Presentation

LO 1 48
Long-Term Liabilities (3 of 4)
Illustration
BE5.9 Included in Adams Company’s December 31, 2020,
trial balance are the following accounts: Accounts Payable
$220,000, Pension Liability $375,000, Discount on Bonds
Payable $29,000, Unearned Rent Revenue $41,000, Bonds
Payable $400,000, Salaries and Wages Payable $27,000,
Interest Payable $12,000, and Income Taxes Payable
$29,000. Prepare the long-term liabilities section of the
balance sheet.

LO 1 49
Long-Term Liabilities (4 of 4)
Illustration
BE5.9 Prepare the long-term liabilities section of the
balance sheet.
Long-term liabilities
Pension Liability $375,000
Bonds payable 400,000
Discount on bonds payable (29,000)
Total $746,000

LO 1 50
Classification in the Statement of financial position
Owners’ Equity

Stockholders' Equity Section

1. Capital Stock. Par or stated value of the shares issued.
2. Additional Paid-in Capital. Excess of amounts paid in
over the par or stated value.
3. Retained Earnings. Corporation's undistributed earnings.
4. Accumulated Other Comprehensive Income. Aggregate
amount of other comprehensive income items.

LO 1 51
Owners’ Equity
Stockholders' Equity Section
5. Treasury Stock. Generally, the cost of shares
repurchased.
6. Noncontrolling Interest (Minority Interest). Portion of
the equity of subsidiaries not wholly owned by the
reporting company.

LO 1 52
Owners’ Equity
Statement of financial position
Presentation (in thousands)

LO 1 53
Owners’ Equity (1 of 2)
Illustration
BE5.10 Hawthorn Corporation’s adjusted trial balance
contained the following accounts at December 31, 2020:
Retained Earnings $120,000, Common Stock $750,000,
Bonds Payable $100,000, Paid-in Capital in Excess of Par—
Common Stock $200,000, Goodwill $55,000, Accumulated
Other Comprehensive Loss $150,000, and Noncontrolling
Interest $35,000.
Prepare the stockholders’ equity section of the balance
sheet.
LO 1 54
Owners’ Equity (2 of 2)
Illustration
BE5.10 Prepare the stockholders’ equity section of the
balance sheet.
Stockholders’ equity
Common stock $750,000
Paid-in capital in excess of par 200,000 $950,000
Retained earnings 120,000
Accumulated other comprehensive income (150,000)
Equity attributable to Hawthorn Corporation 920,000
Noncontrolling interest 35,000
Total stockholders’ equity $955,000

LO 1 55
Learning Objective 2
Prepare a Classified Statement of
financial position

56
Preparation of the Statement of
financial position
Classified Balance Sheet
• Account form
• Report form

Accounting Trends and Techniques (New York: AICPA)

indicates that all of the 500 companies surveyed use either
the “report form” (484) or the “account form” (16),
sometimes collectively referred to as the “customary form.”

LO 2 57
Report Form (1 of 2)
Assets

LO 2 58
Report Form (2 of 2)
Liabilities and Equity

LO 2 59
Learning Objective 3
Explain the Purpose, Content, and
Preparation of the Statement of Cash Flows

60
Purpose of the Statement of Cash
Flows
To provide relevant information about the cash receipts
and cash payments of an enterprise during a period.
The statement provides answers to the following
questions:
1. Where did the cash come from?
2. What was the cash used for?
3. What was the change in the cash balance?

LO 3 61
Content of the Statement of Cash Flows
Three different activities:
1. Operating activities involve the cash effects of
transactions that enter into the determination of net
income.
2. Investing activities include making and collecting loans
and acquiring and disposing of investments and
property, plant, and equipment.
3. Financing activities involve liability and owners’ equity
items.
LO 3 62
Content of the Statement of Cash Flows
Basic Format of Cash Flow Statement

Statement of Cash Flows

Cash flows from operating activities $XXX
Cash flows from investing activities XXX
Cash flows from financing activities XXX
Net increase (decrease) in cash XXX
Cash at beginning of year XXX
Cash at end of year $XXX

LO 3 63
Cash Inflows and Outflows

LO 3 64
Preparation of the Statement of Cash
Flows
Sources of Information
Information obtained from several sources:
1. comparative balance sheets,
2. the current income statement, and
3. selected transaction data.

LO 3 65
Preparation of the Statement of Cash
Flows Illustration
On January 1, 2020, in its first year of operations,
Telemarketing Inc. issued 50,000 shares of $1 par value
common stock for $50,000 cash. The company rented its
office space, furniture, and telecommunications equipment
and performed marketing services throughout the first year.
In June 2020, the company purchased land for $15,000. The
following illustration shows the company’s comparative
balance sheets at the beginning and end of 2020.

LO 3 66
Statement of Cash Flows Illustration (1 of 2)
Comparative Balance Sheets
Telemarketing Inc.
Balance Sheets
Dec. 31, 2020 Jan. 1, 2020 Increase/Decrease
Assets
Cash $31,000 $-0- $31,000 Increase
Accounts receivable 41,000 -0- 41,000 Increase
Land 15,000 -0- 15,000 Increase
Total $87,000 $-0-
Liabilities and Stockholders' Equity
Accounts payable $12,000 $-0- 12,000 Increase
Common stock 50,000 -0- 50,000 Increase
Retained earnings 25,000 -0- 25,000 Increase
Total $87,000 $-0-

LO 3 67
Statement of Cash Flows Illustration (2 of 2)
Income Statement
Telemarketing Inc.
Income Statement
For the Year Ended December 31, 2020
Revenues $172,000
Operating expenses 120,000
Income before income tax 52,000
Income tax 13,000
Net income $ 39,000

Additional information:
Dividends of $14,000 were paid during the year.
LO 3 68
Preparing the Statement of Cash Flows
Four steps:
1. Determine the net cash provided by (or used in) operating
activities.
2. Determine the net cash provided by (or used in) investing
and financing activities.
3. Determine the change (increase or decrease) in cash
during the period.
4. Reconcile the change in cash with the beginning and the
ending cash balances.

LO 3 69
Cash Provided by Operating Activities

LO 3 70
Statement of Cash Flows
Next, the company determines its investing and financing activities.

LO 3 71
Statement of Cash Flows (1 of 3)
Illustration
BE5.12 Keyser Beverage Company reported the following items in the most recent year.

Net income $40,000

Dividends paid 5,000
Increase in accounts receivable 10,000
Increase in accounts payable 7,000
Purchase of equipment 8,000
Depreciation expense (capital expenditure) 4,000
Issue of notes payable 20,000

Required: Compute net cash provided by operating activities.

LO 3 72
Statement of Cash Flows (2 of 3)
Illustration
BE5.12 Compute net cash provided by operating activities.

Operating Activities
Net income $40,000
Depreciation expense 4,000
Increase in accounts receivable (10,000)
Increase in accounts payable 7,000
Net cash provided by operating activities 41,000

LO 3 73
Statement of Cash Flows (3 of 3)
Illustration
BE5.12 Keyser Beverage Company reported the following items in the most recent year.

Net income $40,000

Dividends paid 5,000
Increase in accounts receivable 10,000
Increase in accounts payable 7,000
Purchase of equipment (capital expenditure) 8,000
Depreciation expense 4,000
Issue of notes payable 20,000

Required: Compute net change in cash during the year.

LO 3 74
BE5.12 Illustration
Operating Activities
Net income $40,000
Depreciation expense 4,000
Increase in accounts receivable (10,000)
Increase in accounts payable 7,000
Net cash provided by operating activities 41,000
Investing Activities
Purchase of equipment (8,000)
Financing Activities
Issue notes payable 20,000
Dividends paid (5,000)
Net cash flow from financing activities 15,000
Net increase in cash $48,000

LO 3 75
Statement of Cash Flows (1 of 2)
Review Question
In preparing a statement of cash flows, which of the following
transactions would be considered an investing activity?
a. Sale of equipment at book value
b. Sale of merchandise on credit
c. Declaration of a cash dividend
d. Issuance of bonds payable at a discount.

LO 3 76
Statement of Cash Flows (2 of 2)
Review Question Answer
In preparing a statement of cash flows, which of the following
transactions would be considered an investing activity?
a. Answer: Sale of equipment at book value
b. Sale of merchandise on credit
c. Declaration of a cash dividend
d. Issuance of bonds payable at a discount.

LO 3 77
Significant Noncash Activities
Significant financing and investing activities that do not affect
cash are reported in either a separate schedule at the bottom
of the statement of cash flows or in the notes.
Examples include:
• Issuance of common stock to purchase assets
• Conversion of bonds into common stock
• Issuance of debt to purchase assets
• Exchanges of long-lived assets

LO 3 78
Comprehensive Statement of Cash Flows (1 of 2)
Nestor Company
Statement of Cash Flows
For the Year Ended December 31, 2020
Cash flows from operating activities
Net income $320,750
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense $ 88,400
Amortization of intangibles 16,300
Gain on sale of plant assets (8,700)
Increase in accounts receivable (net) (11,000)
Decrease in inventory 15,500
Decrease in accounts payable (9,500) 91,000
Net cash provided by operating activities 411,750

LO 3 79
Comprehensive Statement of Cash Flows (2 of 2)
Cash flows from investing activities
Sale of plant assets 90,500
Purchase of equipment (182,500)
Purchase of land (70,000)
Net cash used by investing activities (162,000)
Cash flows from financing activities
Payment of cash dividend (19,800)
Issuance of common stock 100,000
Redemption of bonds (50,000)
Net cash provided by financing activities 30,200
Net increase in cash 279,950
Cash at beginning of year 135,000
Cash at end of year $414,950
Noncash investing and financing activities
Purchase of equipment through issuance of $50,000 of bonds

LO 3 80
Usefulness of the Statement of Cash
Flows (1 of 5)
Without cash, a company will not survive.
Cash flow from Operations:
• High amount – company is able to generate sufficient cash
to pay its bills.
• Low amount - company may have to borrow or issue equity
securities to pay bills.

LO 3 81
Usefulness of the Statement of Cash
Flows (2 of 5)
Financial Liquidity
Net Cash Provided by Operating Activities Current Cash

Average Current Liabilities Debt Coverage

Ratio indicates whether the company can pay off its

current liabilities from internally generated cash flows. A
ratio near 1:1 is good.

LO 3 82
Usefulness of the Statement of Cash
Flows (3 of 5)
Financial Flexibility
Net Cash Provided by Operating Activities Cash Debt

Average Total Liabilities Coverage

Ratio indicates a company’s ability to repay its liabilities

from net cash provided by operating activities, without
having to liquidate the assets employed in its operations.

LO 3 83
Usefulness of the Statement of Cash
Flows (4 of 5)
Free Cash Flow
Net Cash Provided
Capital Free
by Operating   Cash Dividends 
Expenditures Cash Flow
Activities

The amount of discretionary cash flow a company has

that may be used for purchasing additional investments,
retiring its debt, purchasing treasury stock, or simply
adding to its liquidity.

LO 3 84
Usefulness of the Statement of Cash
Flows (5 of 5)
Free Cash Flow Computation
Nestor Company
Free Cash Flow Analysis
Net cash provided by operating activities $411,750
Less: Capital expenditures 252,500
Dividends 19,800
Free cash flow $139,450

LO 3 85
Learning Objective 4
Describe Additional Types of Information
Provided

86
Additional Information
Notes to the Financial Statements
• An integral part of reporting financial statement
information
• Explain in qualitative terms information related to specific
financial statement items
• Provide supplemental data of a quantitative nature to
expand information in financial statements
• Explain restrictions imposed by financial arrangements or
basic contractual agreements
LO 4 87
Notes to the Financial Statements (1 of 6)
Accounting Policies
• Specific principles, bases, conventions, rules, and practices
applied in preparing and presenting financial information
• GAAP recommends disclosure for all significant accounting
principles and methods
• For instance, LIFO and FIFO, double-declining-balance and
straight-line, carrying investments at amortized cost, equity,
and fair value
• First footnote generally “Summary of Significant Accounting
Policies”
LO 4 88
Notes to the Financial Statements (2 of 6)
Contractual Situations
• Disclose in the notes, if significant
• Must clearly state essential provisions of lease contracts,
pension obligations, and stock compensation plans in the
notes
• Must disclose the following commitments if amounts are
material: obligations to maintain working capital, to limit
the payment of dividends, to restrict the use of assets, and
to require the maintenance of certain financial ratios

LO 4 89
Notes to the Financial Statements (3 of 6)
Contingencies
• Existing situation involving uncertainty as to possible gain
(gain contingency) or loss (loss contingency)
• Are material events with an uncertain future
• Gain contingencies include tax operating–loss carryforwards
or company litigation against another party
• Loss contingencies relate to litigation, environmental issues,
possible tax assessments, or government investigations

LO 4 90
Notes to the Financial Statements (4 of 6)
Fair Values
• Fair value information may be more useful than
historical cost for certain assets and liabilities
• Financial instruments are defined as cash, an
ownership interest, or a contractual right to receive or
obligation to deliver cash or another financial
instrument
• Cash, investments, accounts receivable, and payables
are examples of financial instruments

LO 4 91
Notes to the Financial Statements (5 of 6)
Three Levels of Fair Value Hierarchy
• Level 1 measures (least subjective) are based on
observable inputs, such as market prices for identical
assets or liabilities
• Level 2 measures (more subjective) are based on
market-based inputs such as those based on market
prices for similar assets or liabilities
• Level 3 measures (most subjective) are based on
unobservable inputs, such as a company’s own data or
assumptions.

LO 4 92
Notes to the Financial Statements (6 of 6)
Fair Values
For major groups of assets and liabilities, companies must
make the following fair value disclosures:
1. the fair value measurement and
2. the fair value hierarchy level of the measurements as a
whole, classified by Level 1, 2, or 3.

LO 4 93
Techniques of Disclosure (1 of 5)
• Parenthetical Explanations
• Cross-Reference and Contra Items
• Supporting Schedules
• Terminology

LO 4 94
Techniques of Disclosure (2 of 5)
Parenthetical Explanations

LO 4 95
Techniques of Disclosure (3 of 5)
Cross-Referencing and Contra Items
Current Assets (in part)
Cash on deposit with sinking fund trustee for redemption of
bonds payable—see Current liabilities $800,000

Current Liabilities (in part)

Bonds payable to be redeemed in 2021—see Current assets $2,300,000

LO 4 96
Techniques of Disclosure (4 of 5)
Supporting Schedules

LO 4 97
Techniques of Disclosure (5 of 5)
Terminology
• Balance sheets should contain descriptions that readers
will generally understand and clearly interpret
• Profession has recommended that
• companies use the word reserve only to describe an
appropriation of retained earnings
• use of the word surplus be discontinued in balance sheet
presentations of stockholders’ equity

LO 4 98
Learning Objective 5
Identify the Major Types of Financial Ratios
and What They Measure

99
Appendix 5A: Ratio Analysis — A
Reference (1 of 4)
Major Types of Ratios
Liquidity Ratios. Measures of the company's short-term ability to
pay its maturing obligations.
Activity Ratios. Measures of how effectively the company uses its
assets.
Profitability Ratios. Measures of the degree of success or failure of
a given company or division for a given period of time.
Coverage Ratios. Measures of the degree of protection for long-
term creditors and investors.

LO 5 100
Appendix 5A: Ratio Analysis — A
Reference (Liquidity and Activity) (2 of 4)
Ratio Formula Purpose or Use
I. Liquidity
1. Current ratio Current assets
Measures short-term debt-paying ability
Current liabilities
2. Quick or acid-test Cash  short-term investments 
ratio Accounts receivable (net) Measures immediate short-term liquidity
Current liabilities
3. Current cash debt Net cash provided by Measures a company's ability to pay off its
coverage operating activities current liabilities in a given year from its
Average current liabilities operations
II. Activity
4. Accounts Receivable
turnover
Net sales Measures liquidity of receivables
Average net accounts receivable
5. Inventory turnover
Cost of goods sold Measures liquidity of inventory
Average inventory
6. Asset turnover Measures how efficiently assets are used
Net sales to generate sales
Average total assets

LO 5 101
Appendix 5A: Ratio Analysis — A
Reference (Profitability) (3 of 4)
Ratio Formula Purpose or Use
III. Profitability
7. Profit margin on sales Net income Measures net income generated by each
Net sales dollar of sales
8. Return on assets
Net income Measures overall profitability of assets
Average total assets
9. Return on common Net income  Preferred dividends Measures profitability of owners'
stockholders’ equity investment
Average common stockholders' equity
10. Earnings per share Net income  Preferred dividends
Measures net income earned on each
Weighted-average common shares outstanding
share of common stock
11. Price-earnings ratio Measures the ratio of the market price per
Market price per share share to earnings per share
Earnings per share
12. Payout ratio Measures percentage of earnings
Cash dividends distributed in the form of cash dividends
Net income

LO 5 102
Appendix 5A: Ratio Analysis — A
Reference (Coverage) (4 of 4)
Ratio Formula Purpose or Use

IV. Coverage
13. Debt to assets ratio Total liabilities Measures the percentage of total
Total assets assets provided by creditors
14. Times interest Net income  Interest expense 
earned Income tax expense
Measures ability to meet interest
payments as they come due
Interest expense
15. Cash debt coverage Net cash provided by operating activities Measures a company's ability to repay
Average total liabilities its total liabilities in a given year from
its operations
16. Book value per Measures the amount each share
share Common stockholders' equity would receive if the company were
Outstanding shares liquidated at the amounts reported on
the balance sheet
17. Free cash flow Measures the amount of discretionary
Net cash provided by operating cash flow
activities  Capital expenditures  Cash dividends

LO 5 Copyright ©2019 John Wiley & Sons, Inc. 103

Learning Objective 6
Compare the Accounting Procedure Related
to the Balance Sheet Under GAAP and IFRS

104
IFRS Insights (1 of 3)
Relevant Facts - Similarities
• Both IFRS and GAAP allow the use of title “balance sheet” or “statement of
financial position.” IFRS recommends but does not require the use of the title
“statement of financial position” rather than balance sheet.
• Both IFRS and GAAP require disclosures about (1) accounting policies
followed, (2) judgments that management has made in the process of
applying the entity’s accounting policies, and (3) the key assumptions and
estimation uncertainty that could result in a material adjustment to the
carrying amounts of assets and liabilities within the next financial year.
Comparative prior period information must be presented and financial
statements must be prepared annually.
• IFRS and GAAP require presentation of non-controlling interests in the equity
section of the balance sheet.

LO 6 105
IFRS Insights (2 of 3)
Relevant Facts - Differences
• IFRS requires a classified statement of financial position except in very limited
situations. IFRS follows the same guidelines as this text for distinguishing
between current and noncurrent assets and liabilities. However, under GAAP,
public companies must follow SEC regulations, which require specific line
items.
• Under IFRS, current assets are usually listed in the reverse order of liquidity.
For example, under GAAP cash is listed first, but under IFRS it is listed last.
• IFRS has many differences in terminology. For example in the equity section
common stock is called share capital—ordinary.
• Use of the term “reserve” is discouraged in GAAP, but there is no such
prohibition in IFRS.

LO 6 106
 Thank you

End of chapter 3