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Balance Sheet15.501/516 AccountingSpring 2004Professor S.RoychowdhurySloan School of ManagementMassachusetts Institute of TechnologyFeb 09, 20031

Some residual administrativematters Access web pagePass/Fail – YesAudit – NoFirst point of contact: TAsSyllabus2

Questions from last class Do private companies file with the SEC? Only if they have public debtoutstanding.3

Financial Statements – theAnnual Report Management DiscussionAuditors ReportConsolidated Balance SheetConsolidated Net IncomeConsolidated Statement of StockholdersEquityConsolidated Cash Flow StatementsNotes to Accounts4

Balance Sheet: Assets Assets Probable future economic benefitsobtained or controlled by a particular entityas a result of past transactions or events.The specific types of assets a firm ownsdepends on the nature of its business -manufacturing (e.g., General Motors) vs.merchandising (e.g., K mart) vs. financial(e.g., Citicorp) vs. service (e.g., H & RBlock) business.5

Balance Sheet: Assets Current assets Cash and other assets that are reasonablyexpected to be realized in cash or consumedduring the normal operating cycle of the businessor within one year, whichever is longer.longer Cash and cash equivalentsShort-term investments -- at market value -- We willdiscuss this in detail later.Accounts receivable -- Net realizable valueInventory -- Lower of Historical Cost or Market Value(current replacement cost)Prepaid expenses6

The Operating Cycle Definition: an operating cycle is defined as the elapsed timebetween the start of production and the eventual receipt cashfrom customers from the sale of the productCashpaymentCashcollectionsale InventoryAccts. Rec.(Raw material to finished goods)Operating cycle7

Balance Sheet: Assets Long-Term Investments Investments intended to be held for a period oftime usually extending beyond one year.Debt and equity securities such as stocks,bonds, and long-term notes receivable.Tangible assets not currently used inoperations, e.g., land held for investmentpurposes.8

Balance Sheet: Assets Property, Plant, and Equipment Assets of a durable nature that are to be usedin the production or sale of goods, orrendering of services, rather than being heldfor sale. Machinery, Factory Building, etc.Carried at Cost (-) Accumulated DepreciationLand on which the company conducts itsoperations is carried on the balance sheet atthe original cost – no depreciation. Distinguish from land held for investment purposes.9

Balance Sheet: Assets Intangible Assets Non-current, non-physical assets of a business, thepossession of which provides uncertain future benefits tothe owner Is accounts receivable an intangible asset? E.g., goodwill, trademarks, patents, copyrights, etc.Not for accounting purposesIntangible assets are carried on the balance sheetat cost (-) accumulated amortization.Cost Whatever was paid to acquire them.Internally generated intangible assets are notshown as assets10

Balance Sheet: Liabilities Liabilities Probable future economic sacrifices arisingfrom present obligations of a particular entity totransfer assets or provide services to otherentities in the future as a result of pasttransactions or events.Current Liabilities Obligations that are expected to be paid (orservices expected to be performed) with the use ofassets that are listed in the current section of thebalance sheet.11

Balance Sheet: Liabilities Examples of current liabilities accounts payable, wages payable, interestpayable, income taxes payable, deferredrevenues.Current portion of long-term debts areclassified as current liabilities.However, debt expected to be refinancedthrough another long-term debt are treated aslong-term liabilities. What is the intuition here?12

Balance Sheet: Liabilities Long-Term Liabilities Obligations usually expected to requirepayment over a period of time beyond oneyear.Usually financing obligations, e.g., arisingfrom issuance of bonds, long-term notes,and mortgages.The maturity date, the rate of interest, andany security pledged to support theborrowing agreement should be clearlyshown.13

Balance Sheet: Owners’ Equity Stockholders' Equity Contributed Capital The residual interest in the assets thatremain after deducting the liabilities.A measure of the capital contributed to thecompany by its owners.Contribution can be through cash, noncashassets, or valuable services.Different classes of capital: Commonstock and Preferred stockRetained earnings14

Financial Statements: RetainedEarnings & Shareholders’ Equity Retained earnings A measure of undistributed profits of a businessDo not include capital contributed by ownersRetained earnings Cumulative sum of profits earned from the inception ofbusiness –Cumulative sum of all “dividends” distributed to theowners from the inception of businessHow does retained earnings change over a period oftime (e.g., a year) Beginning balance in retained earningsAdd Net income earned during the periodSubtract Dividends distributed during the periodEnding balance in retained earnings15

The Mechanics of Financial AccountingFundamental Accounting EquationAssets Liabilities ContributedCapitalOwners’ EquityRetainedEarnings16

What type of account?Identify assets, liabilities, or equityzzzzzzzEquipmentRetained EarningsPatentCommon StockDividend PayableAccumulated depreciationPrepaid Expense17

What type of account?Identify assets, liabilities, or equityzzzzzzzzSupplies InventoryAccounts ReceivableLandGoodwill developed by firmUnsettled damage suitFactoryIncrease in value of landEmployee payroll taxes payable18

Should we recognize theasset?Assets arise from transactions and eventszzzzA firm issues a 12m check to an insurancecompany for liability insurance over the nextyear.A firm issues a check for 500K as a deposit ona custom-built machine.A firm buys stock in another firm for 325KA firm acquires chemicals to be used as rawmaterials for 800K.19

Should we recognize theasset?Assets arise from transactions and eventszA well-known scientist is hired to manage the R&Dfunction for 480K a year. Employment starts next month.zThe firm receives an order for 15K in products.zThe firm writes a check for 1M to obtain an option topurchase a tract of land.zA firm receives notice from a supplier that it has shippedraw materials of 200K. The firm has title to the goodswhile in transit.zThe firm purchases a patent from its creator for 1.2M20

Should we recognize theliability?Liabilities arise from transactions and eventszThe firm owes its attorneys 50K in legal expenses.zThe firm provides warranties on its products.zThe firm borrows 60K from the bank for a 90-dayperiod.21

Accounting TransactionszWhat business transactions are recorded in thefinancial accounting system?z Exchange of assets and liabilities with other entitiesz As opposed to “executory” transactions zSupplier: I will supply 5,000 units six months from now.Customer: I will pay when I receive the goodsExchange of promisesHow do transactions affect the accountingequation?zThe accounting identity is always maintained22

Joe’s Landscaping Service(1)Joe contributes 10,000 in cashzAssets Liabilities Owners’ EquityzCashz 10,000Contributed Capital 10,00023

Transactions and the Accounting EquationCash A/R 10,000 Equip. L/P C. Cap. R/E 10,00024

(2) The company borrows 3,000 from a bankzAssets Liabilities Owners’ EquityzCashLoans Payablez 3,000 3,00025

Transactions and the Accounting EquationCash A/R Equip. L/P 10,000 3,000C. Cap. R/E 10,000 3,00026

(3) Company purchases equipment for 5,000cashzAssetszCashz- 5,000 L OEEquipment 5,00027

Transactions and the Accounting EquationCash A/R Equip. L/P 10,000R/E 10,000 3,000- 5,000C. Cap. 3,000 5,00028

(4) Company performs service for 12,000. Thecustomer pays 8,000 in cash and promises topay the balance at a later date.zAssetszCashz 8,000 Receivables 4,000L Owners’ EquityRetained Earnings 12,00029

Transactions and the Accounting EquationCash A/R Equip. L/P 10,000R/E 10,000 3,000 3,000- 5,000 8,000C. Cap. 5,000 4,000 12,00030

(5) Company pays 9,000 for expenses (wages,interest, and maintenance)zAssets Liabilities Owners’ EquityzCashz- 9,000Retained Earnings- 9,00031

Transactions and the Accounting EquationCash A/R Equip. L/P 10,000 3,000- 5,000- 9,000R/E 10,000 3,000 8,000C. Cap. 5,000 4,000 12,000- 9,00032

(6) Company pays dividend of 1,000zAssets Liabilities Owners’ EquityzCashz- 1,000Retained Earnings- 1,00033

Transactions and the Accounting EquationCash A/R 10,000 Equip. L/PR/E 10,000 3,000 3,000- 5,000 8,000 C. Cap. 5,000 4,000 12,000- 9,000- 9,000- 1,000- 1,0006,0004,0005,0003,00010,000 2,00034

Balance Sheet as at December 31, 1997AssetsAmountLiabilities andOwners’ EquityAmountCash6,000Loans ipment5,000RetainedEarnings2,000TotalAssests 15,000Total Liabilitiesand Owners’Equity3,000 15,00035

Transactions and Accounting EquationCash A/R Equip. L/P C. Cap. R/E 10,000 10,000 3,000 3,000- 5,000 8,000 5,000 4,000 12,000- 9,000- 9,000- 1,000- 1,0006,0004,0005,0003,00010,000 2,00036

Income StatementFor the year ended December 31, 1997Revenues: Fees earned for service 12,000Expenses: Wages, interest, maintenance 9,000Net income 3,00037

Transactions and Accounting EquationCash A/R 10,000 Equip. L/PC. Cap. R/E 10,000 3,000 3,000 5,000- 5,000 8,000 4,000 12,000- 9,000- 9,000- 1,000- 1,0006,0004,0005,0003,00010,000 2,00038

Statement of Cash FlowsFor the year ended December 31, 1997[To be revisited later in the course]Operating activities:Sale of a service (4)Payments for expenses (5)Net cash from operating activitiesInvesting activities:Purchase of equipment (3)Net cash from investing activitiesFinancing activities:Borrowings (2)Owner contributions (1)Payment of dividends (6)Increase in cash balanceCash balance at the beginning of the yearCash balance at the end of the ,000)12,0006,0000396,000

Statement of Retained EarningsFor the year ended December 31, 1997Beginning retained earnings balance0Plus: Net income3,000Less: Dividend to stockholder1,000Ending retained earnings balance 2,00040

Summary Balance sheet Listing of Resources owned by a firm (assets orinvestments)Financing of the assets through obligations toexternal parties (liabilities)Financing of the investments through residualclaimants (shareholders’ equity)Preparing a balance sheet (and otherfinancial statements) using transactionhistory41

Home work problem:Initial Balance SheetStarting a Company (1) Issues 50,000 shares of 10 par value commonstock at par value for cash.(2) Acquires land and building costing 225,000 withthe payment of 50,000 cash and the assumption ofa 20-year, 8-percent mortgage for the balance.(3) Purchases a used crane for 13,200 cash(4) Acquires raw materials costing 8,600 onaccount.42

Initial Balance SheetStarting a Company (5) Returns defective raw materials purchased in (4)and costing 900 to the supplier. The account hasnot yet been paid.(6) Pays the supplier in (4) and (5) the amount due,less a 2-percent discount for prompt payment. Thefirm treats cash discount as a reduction in theacquisition cost of raw materials.(7) Obtains a fire insurance policy providing 500,000coverage beginning next month. It pays the 1-yearpremium of 4,950.43

Initial Balance SheetStarting a Company (8) Issues a check for 1,800 for 3 months rent inadvance for office space.(9) Purchases a patent on a machine process for 90,000 cash.(10) Purchases office equipment for 2,700, makinga down payment of 250 and agreeing to pay thebalance in 30 days.(11) Pays 825 to Express Trucking Company fordelivering the equipment purchased in (3).44

Recording of transactionsCash OCA PP&E ONCA CL NCL SE(1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)45

Non-current, non-physical assets of a business, the possession of which provides uncertain future benefits to the owner E.g., goodwill, trademarks, patents, copyrights, etc. Is accounts receivable an intangible asset? Not for accounting purposes Intangible assets are carried on the balance sheet at cost (-) accumulated amortization.