Questions for Review of Key Topics
The purpose of the balance sheet, also known as the statement of financial position, is to present the financial position of the company on a particular date. Unlike the income statement, which is a change statement that reports events occurring during a period of time, the balance sheet is a statement that presents an organized array of assets, liabilities, and shareholders’ equity at a point in time. It is a freeze frame or snapshot picture of financial position at the end of a particular day marking the end of an accounting period.
The balance sheet does not portray the market value of the entity for a number of reasons. Most assets are not reported at market value, but instead are measured according to historical cost. Also, there are certain resources, such as trained employees, an experienced management team, and a good reputation, that are not recorded as assets at all. Therefore, the assets of a company minus its liabilities, as shown in the balance sheet, will not be representative of the company’s market value.
Current assets include cash and other assets that are reasonably expected to be converted to cash or consumed during one year, or within the normal operating cycle of the business if the operating cycle is longer than one year. The typical asset categories classified as current assets include:
— Cash and cash equivalents
— Short-term investments
— Accounts receivable
— Prepaid expenses
Current liabilities are those obligations that are expected to be satisfied through the use of current assets or the creation of other current liabilities. So, this classification will include all liabilities that are scheduled to be liquidated within one year or the operating cycle, whichever is longer, except those that management intends to refinance on a long-term basis. The typical liability categories classified as current liabilities include:
— Accounts payable
— Short-term notes payable
— Accrued liabilities
— Current maturities of long-term debt
Answers to Questions (continued)
The operating cycle for a typical manufacturing company refers to the period of time required to convert cash to raw materials, raw materials to a finished product, finished product to receivables, and then finally receivables back to cash.
Investments in equity securities are classified as current if the company’s management (1) intends to liquidate the investment in the next year or operating cycle, whichever is longer, and (2) has the ability to do so, i.e., the investment is marketable. If either of these criteria does not hold, the investment is classified as noncurrent.
The common characteristics that these assets have in common are that they are tangible, long-lived assets used in the operations of the business. They usually are the primary revenue-generating assets of the business. These assets include land, buildings, equipment, machinery, furniture and other assets used in the operations of the business, as well as natural resources, such as mineral mines, timber tracts and oil wells.
Property, plant, and equipment and intangible assets each represent assets that are long-lived and are used in the operations of the business. The difference is that property, plant, and equipment represent physical assets, while intangibles lack physical substance. Generally, intangibles represent the ownership of an exclusive right, such as a patent, copyright or franchise.
A note payable of $100,000 due in five years would be classified as a long-term liability. A $100,000 note due in five annual installments of $20,000 each would be classified as a $20,000 current liability —...