Classify each of the following financial statement items

A Further Look at Financial Statements

 CHAPTER PREVIEW 

If you are thinking of purchasing Best Buy stock, or any stock, how can you decide what the shares are worth? If you manage Columbia Sportswear's credit department, how should you determine whether to extend credit to a new customer? If you are a financial executive at Google, how do you decide whether your company is generating adequate cash to expand operations without borrowing? Your decision in each of these situations will be influenced by a variety of considerations. One of them should be your careful analysis of a company's financial statements. The reason: Financial statements offer relevant and reliable information, which will help you in your decision‐making.

In this chapter, we take a closer look at the balance sheet and introduce some useful ways for evaluating the information provided by the financial statements. We also examine the financial reporting concepts underlying the financial statements. We begin by introducing the classified balance sheet.

Just Fooling Around?

Few people could have predicted how dramatically the Internet would change the investment world. One of the most interesting results is how it has changed the way ordinary people invest their savings. More and more people are striking out on their own, making their own investment decisions.

Two early pioneers in providing investment information to the masses were Tom and David Gardner, brothers who created an online investor website called The Motley Fool. The name comes from Shakespeare's As You Like It. The fool in Shakespeare's play was the only one who could speak unpleasant truths to kings and queens without being killed. Tom and David view themselves as 21st‐century “fools,” revealing the “truths” of the stock market to the small investor, who they feel has been taken advantage of by Wall Street insiders. The Motley Fool's online bulletin board enables investors to exchange information and insights about companies.

Critics of these bulletin boards contend that they are simply high‐tech rumor mills that cause investors to bid up stock prices to unreasonable levels. For example, the stock of PairGain Technologies jumped 32% in a single day as a result of a bogus takeover rumor on an investment bulletin board. Some observers are concerned that small investors—ironically, the very people the Gardner brothers are trying to help—will be hurt the most by misinformation and intentional scams.

To show how these bulletin boards work, suppose that you had $10,000 to invest. You were considering Best Buy Company, the largest seller of electronics equipment in the United States. You scanned the Internet investment bulletin boards and found messages posted by two different investors. Here are excerpts from actual postings:

TMPVenus: “Where are the prospects for positive movement for this company? Poor margins, poor management, astronomical P/E!”

broachman: “I believe that this is a LONG TERM winner, and presently at a good price.”

One says sell, and one says buy. Whom should you believe? If you had taken “broachman's” advice and purchased the stock, the $10,000 you invested would have been worth over $300,000 five years later. Best Buy was one of America's best‐performing stocks during that period of time.

Rather than getting swept away by rumors, investors must sort out the good information from the bad. One thing is certain—as information services such as The Motley Fool increase in number, gathering information will become even easier. Evaluating it will be the harder task.

LEARNING OBJECTIVE 1

Identify the sections of a classified balance sheet.

In Chapter 1, you learned that a balance sheet presents a snapshot of a company's financial position at a point in time. It lists individual asset, liability, and stockholders' equity items. However, to improve users' understanding of a company's financial position, companies often use a classified balance sheet instead. A classified balance sheet groups together similar assets and similar liabilities, using a number of standard classifications and sections. This is useful because items within a group have similar economic characteristics. A classified balance sheet generally contains the standard classifications listed in Illustration 2-1.

Assets

Liabilities and Stockholders' Equity

Current assets

      Current liabilities

Long-term investments

      Long-term liabilities

Property, plant, and equipment

      Stockholders' equity

Intangible assets

ILLUSTRATION 2-1 Standard balance sheet classifications

These groupings help financial statement readers determine such things as (1) whether the company has enough assets to pay its debts as they come due, and (2) the claims of short‐ and long‐term creditors on the company's total assets. Many of these groupings can be seen in the balance sheet of Franklin Corporation shown in Illustration 2-2. In the sections that follow, we explain each of these groupings.

FRANKLIN CORPORATION

Balance Sheet

October 31, 2017

Assets

Current assets

 Cash

$ 6,600

 Debt investments

2,000

 Accounts receivable

7,000

 Notes receivable

1,000

 Inventory

3,000

 Supplies

2,100

 Prepaid insurance

    400

  Total current assets

$22,100

Long-term investments

 Stock investments

5,200

 Investment in real estate

  2,000

7,200

Property, plant, and equipment

 Land

10,000

 Equipment

$24,000

 Less: Accumulated depreciation—equipment

  5,000

  19,000

29,000

Intangible assets

 Patents

  3,100

Total assets

$61,400

Liabilities and Stockholders' Equity

Current liabilities

 Notes payable

$11,000

 Accounts payable

2,100

 Unearned sales revenue

900

 Salaries and wages payable

1,600

 Interest payable

    450

  Total current liabilities

$16,050

Long-term liabilities

 Mortgage payable

10,000

 Notes payable

   1,300

  Total long-term liabilities

 11,300

      Total liabilities

27,350

Stockholders' equity

 Common stock

14,000

 Retained earnings

 20,050

      Total stockholders' equity

 34,050

Total liabilities and stockholders' equity

$61,400

ILLUSTRATION 2-2 Classified balance sheet

▼ HELPFUL HINT

Recall that the accounting equation is Assets=Liabilities+Stockholders' EquityRecall that the accounting equation is Assets=Liabilities+Stockholders' Equity.

CURRENT ASSETS

Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2-2, Franklin Corporation had current assets of $22,100. For most businesses, the cutoff for classification as current assets is one year from the balance sheet date. For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use the supplies in operations within one year.

Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year. The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers. For most businesses, this cycle takes less than a year, so they use a one‐year cutoff. But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long‐term.

Common types of current assets are (1) cash, (2) investments (such as short‐term U.S. government securities), (3) receivables (accounts receivable, notes receivable, and interest receivable), (4) inventories, and (5) prepaid expenses (insurance and supplies). Companies list current assets in the order in which they expect to convert them into cash. Follow this rule when doing your homework.

Illustration 2-3 presents the current assets of Southwest Airlines Co. in a recent year.

SOUTHWEST AIRLINES CO.

Balance Sheet (partial)

(in millions)

Current assets

 Cash and cash equivalents

$1,355

 Short-term investments

1,797

 Accounts receivable

419

 Inventories

467

 Prepaid expenses and other current assets

   418

  Total current assets

$4,456

ILLUSTRATION 2-3 Current assets section

As explained later in the chapter, a company's current assets are important in assessing its short‐term debt‐paying ability.

LONG‐TERM INVESTMENTS

Long‐term investments are generally (1) investments in stocks and bonds of other corporations that are held for more than one year, (2) long‐term assets such as land or buildings that a company is not currently using in its operating activities, and (3) long‐term notes receivable. In Illustration 2-2, Franklin Corporation reported total long‐term investments of $7,200 on its balance sheet.

Google Inc. reported long‐term investments on its balance sheet in a recent year as shown in Illustration 2-4.

GOOGLE INC.

Balance Sheet (partial)

(in millions)

Long-term investments

 Non-marketable equity investments

$1,469

ILLUSTRATION 2-4 Long‐term investments section

ALTERNATIVE TERMINOLOGY

Long‐term investments are often referred to simply as investments.

PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business. This category includes land, buildings, equipment, delivery vehicles, and furniture. In Illustration 2-2, Franklin Corporation reported property, plant, and equipment of $29,000.

Depreciation is the allocation of the cost of an asset to a number of years. Companies do this by systematically assigning a portion of an asset's cost as an expense each year (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset's life. In Illustration 2-2, Franklin Corporation reported accumulated depreciation of $5,000.

Illustration 2-5 presents the property, plant, and equipment of Tesla Motors, Inc. in a recent year.

TESLA MOTORS, INC.

Balance Sheet (partial)

(in thousands)

Property, plant, and equipment

 Machinery, equipment and office furniture

$ 322,394 

 Tooling

230,385 

 Leasehold improvements

94,763 

 Building and building improvements

67,707 

 Land

45,020 

 Computer equipment and software

42,073 

 Construction in progress

   76,294 

878,636 

 Less: Accumulated depreciation and amortization

  (140,142)

 Total

$ 738,494 

ILLUSTRATION 2-5 Property, plant, and equipment section

ALTERNATIVE TERMINOLOGY

Property, plant, and equipment is sometimes called fixed assets or plant assets.

INTANGIBLE ASSETS

Many companies have assets that do not have physical substance and yet often are very valuable. We call these assets intangible assets . One common intangible is goodwill. Others include patents, copyrights, and trademarks or trade names that give the company exclusive right of use for a specified period of time. In Illustration 2-2, Franklin Corporation reported intangible assets of $3,100.