CFA Level 1 (2009) - 3

Study Session 8

Cross-Reference to CFA Institute Assigned Reading #33 - Understanding the Balance Sheet

f OS .\.Lt

Assets arc probable future economic benefits owned or controlled by an entiry as a result oC previous transactions.

Liabilities arc obligations owed by an emity Crom previous transactions that are expected to result in an outHow of economic benefits in the future.

Stockholders' equity is the residual iI1lerest in assets that remains after subtracting an entity's liabilities. Equity = assets -liabilities.

The balance sheet provides information about a company's assets, how it raises capital, probable cash flows from inventory and receivables, its liabilities, its short-term liquidity. and usc of f1nancial kverage.

A balance sheet in an account form~lt lists assClS on the left side and liabilities Jnd equilY on the right side. A report format balance sheet lists assets, liabilities, and equity in a single column. A classified balance sheet groups accounts into subtotals such as current assets and current liabilities.

Under accrual accounting, sales in excess of cash collected will create balance sheet assets, and expenditures in excess of cash paid for them will result in balance sheet liabilities.

(OS .33.d

Current (noncurrent) assets are those expected to be used up or convened to cash in less than (more than) one year or the firm's operating cycle, whichever is greater. Current (noncurrent) liabilities are those the firm expects to pay in less than (more than) one year or the firm's operating cycle, whichever is greater.

lOS .noe

Balance sheet values are a mixture of historical COSts and fair values.

Accounts receivable are reponed at net realizable value (based on management's estimates of collectability).

Inventory is reported at the lower of cost or net realizable value.

Tangible noncurrent assets are reponed at their historical costs less accumulated depreciation.

Identifiable intangible assets with definite lives are reported at their historical costs when purchased or, under some circumstances, when created, less accumulated amortization.

be tested for impairment at least annually.

Study Session 8

Cross-Reference to erA Institute Assigned Reading #33 - Understanding the Balance Sheet

LOS .13.1'

Notes [0 the financial statemelHS should disclose information ahout:

The I1rm's accounting policies.

Estimates and assumptions that pose significant risk.

•Tnms of deht agreemeI1ls.

Obligations from off--halance-sheet financing such as operating leases. Business segmelHs.

COI1lingelH assets and liahilities. Pension plans.

LOS :B.g

Held-to-maturity securities are reponed at amonized COSf.

Trading securities arc reponed at fair value, and an)' unrealized gains and losscs arc reponed in net income.

i\vailable-lor-s;J1c securities arlO rcported at fair value, and any unrcalized gains and JosSl"S arc reponed as a component or srockholdns' equiI),.

Bonds and notes payable arc reponed at their amortized cost (proceeds). Derivatives, instruments with exposures hedged by derivatives, and financial liabilities held for trading are reponed at fair value.

LOS :'d.h

Owners' equity includes:

Contrihuted capital-the amOUlH paid in b), common and preferred shareholders.

Minority interest-the parr ion of a subsidiary that is not owned by the p;lrenr.

Retained earnings-the cumulative undistributed earnings of the firm since

InCeption.

Treasury srock-common srock that the firm has repurchased.

•Accumulated other comprehensive income-includes all changes [0 equity from sources other than net income and transactions with shareholders.

LOS :n.i

The statement of changes in equity summarizes the transactions during a period that increase or decrease equity, including transactions with shareholders.

A venical common-size balance sheet expresses each balance sheet item as a percentage of total assets.

Liquidity ratios that can be read from a common-size balance sheet include the current ratio, the quick ratio, and the cash ratio.

Solvency ratios that can be read from a common-siz_e balance sheet include the long-term debt-to-equity ratio, the debt-to-equity ratio, the debt ratio, and the financial leverage ratIo.

Comparisons of ratios among firms may be difficult because of different accounting methods and the judgment and estimates that are involved.

Study Scssion 8

Cross-Reference to eFA Institute Assigned Reading 1133 - Understanding the Balance Sheet

\ , . . . .~

A.stockholders' el]uity = assl'ts - liabilities.

R, liabilities = assClS - stockholders' equit),.

C. assets ~ liabilities - stockholders' equity,

.1. Century C:onlpany's balance sheet follows:

('I'II/!!rl' (,'0 iill'tl II)'

81//'/I/u' S/il'd

(Iii mil//oll.')

20X7 20X6

Stlldy Session 8

Cross-Reference to CFA Institute Assigned Reading #33 - Understanding the Balance Sheet

5.How should the proceeds received from the advance sale of tickets to a sporting event be treated by the seller, assuming the tickets arc nonrefundable?

A.Unearned revenue is recognized to the extent that costs have been incurred.

B.Revenue is recognized to the extent that costs have heen incurred.

C.Revenue is deferred until the sp0rling event is held.

6.Which of the following would must likely n:sult in a currel1l liability?

A.Possible warranty claims.

B.Future operating lease payments.

C.Estimated income taxes for the current year.

7.Which of the following inventory valuation methods is required by the accounting standard-setting bodies?

A.Lower of cost or net realizable value.

B.\X!eighted average cost.

C.hrst-in, first-our.

~.SF Corporation has created employee goodwill by reorganizing its retiremeI1l

lwndit package. An independent managemel1l consuiIal1l estimated the value of the goodwill at $2 million. In addition, Sl~ recendy purchased a patent that was developed by a competitor. The patent has an estimated useful life of five years.

Should SF repon the goodwill and patent on its balance sheet?

9.At the beginning of the year, Parel1l Company purchased all 500,000 shares of Sub Incorporated for $15 per share. Just before the acquisition date, Sub's

balance sheet reported net assets of $6 million. Parent determined the fair value of Sub's property and equipment was $1 million higher than reponed by Sub. What amount of goodwill should Parent repon as a result of its acquisition of Sub?

A.$0.

B.$500,OCO. c. $1,50: ,vOO.

10.Which of the following is least likely to be disclosed in the financial statement footnotes?

A.Off-balance-sheet financing.

B.Contingencies and commitments.

C. Fair value of noncurrent assets used in the production of income.

Study Session H

Cross-Reference to CFA Institute Assigned Reading #33 - Understanding the Balance Sheet

Usc the following information to answer Questions I I and 12.

A[ [he beginning of the year, Company P purchased 1,000 shares of Company S for $80 per share. During [he year, Company S paid a dividend of $4 per share. A[ the end or the year, Company S'sshare price was $75.

II.What amount should Company P report on its halance sheet at year-end ir [he investment in Company S is considered a trading security, and what amount

should be reponed if the investment is considered an available-far-sale security?

J 2. What amount of investment income should Company P recogniLe in its income statement if rhe invesrment in Company S is considered trading, and what amount should be recognized iF [he investmelll is considered availahle-For-salc)

Trading Available~fQl~~ak

13.Miller Corporation has 160,000 shares of common stock authorized. There are 92,000 shares issued and 84,000 shares outstanding. How many shares of

rreasury stock does Miller own?

A.8,000.

R. 68,000

C. 76,000.

14.Selected data from Alpha Company's balance sheet at [he end of the year follows:

Investment in Beta Company, at fair valu.e.. "

Deferred taxes

Common srock, $1 par value

Preferred stock, $100 par value

Retained earnings

Accumulated other comprehensive income

The investment in Beta Company had an original cost of $120,000. Assuming the investment in Beta is classified as available-far-sale, Alpha's total owners' equity at year-end is cLosest to:

A.$ 1,618,000.

B.$ 1,664,000.

C.$ I ,714,000.

Study Session 8

Cross-Reference to erA Institute Assigned Reading #33 - Understanding the Balance Sheet

15.How would [he collection of accounts receivable m05t !ike!y allcn the current

16.Comparing a company's ralios wilh those of its cOI11j1elirors is known ~lS:

A.Longirudinal analysis.

B.Common-sizc analysis.

C.Cross-senional analysis.

Study Session 8

Cross-Reference to CFA Institute Assigned Reading #,U - Understanding the Balance Shcct

. . '

1.C An asset is a future economic bendit obtained or cOlllrollcd as a result of past trallSauions. Some assets arc intangihlc (e.g., goodwill), and others may be donated.

2.C Assets must equal liallilities plus stockholders' l'lJuity. Otherwise, the balance sheet would not balance.

3.A In a repon format, the assets, liabilities, and equity arc presented in one column. A classified balance sheet groups tngether similar items (e.g., CUITelll and nOnCU1'l'elll assets and liabilities) to arrive at significant subtOlals.

IJ. A 'fcnant has simply prepaid its annual payment; rent expense has not yet heen incurred. \X/hen cash is paid in advance of recognizing an expense, one asset (cash) deereases and anorhn assl'l (prepaid expcllScs) inLTeases Il)' rhe same ;ImOllnl. l.i;lbililies are not affect cd.

(,. C Estimated income taxes for the current year arc likely reponed as a current liabililY. To recognize the warranty expense, it mmt be probablc, not just possible. Future operating lease payments arc not reponed on the balance shecl.

7.A Invcntories arc rcquircd to be valued ,][ rhe lower of cost or IIct realizable valuc (or "market" under U.S. CAJ\P). nro and avcrage cost arc two of the invclltory cmt now

assumptions among which a firm has a choicc.

RB Coodwill developed internally is expensed as incurred. The purchased p;llent is reported on the balance sheel.

13.A The difference between the issued shares and the outstanding shares is the treasury shares.

14. B Total stockholders' equity consists of common stock of $550,000, [Jrefcrred slOck of

$175,000, retained earnings of $893,000, and accumu lated other comprehensive income of $46,000, for a total of $ J ,GG4,000. The $30,000 unrealized gain frol11 the investment in Beta is already included in accul11ulated other comprehensive income.

Study Session 8

Cross-Reference to CfA Inscitute Assigned Reading #33 - Understanding the Balance Sheet

15.B The collection of accounts receivable would increase cash and decrease accounts receivable. Thus, current assets would not change and the current ratio would remain lhe same. Since the numerator of the cash ratio oilly includes cash and marketable securities, the collection of" rt'ccivahles would increase the cash ralio.

16.C Comparing ratios of a firm to those of its competitors is known as cross-secrion:t! analysis.

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The f~llowingis a review of the Financial Reponing and Analysis principles designed to address the learning Oulcome statements set forth by CFA Institute"'J. This topic is also covered in:

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UNDERSTANDING THE CASH FLOW STATEMENT

Stud), Session 8

EXAM Focus

THE CASH FLOW STATEMENT

The cash flow statement provides information beyond that availJble from the income SLHcment, which is based on accrual, rather than cash, accounting. The cash How statement provides the following:

•Information about a company's cash receipts and cash payments during an accounting period.

•Information about a company's operating, investing, and financing activities.

•An understanding of the impact of accrual accounting events on cash flows.

The cash flow statement provides information to assess the firm's liquidity, solvency, and financial flexibility. An analyst can use the statement of cash flows to determine whether:

•Regular operations generate enough cash to sustain the business.

• Enough cash is generated to payoff existing debts as they mature.

•The firm is likely to need additional financing.

•Unexpected obligations can be met.

•The firm can take advantage of new business opportunities as they arise.

LOS 34.<\.: Compare and contrast cash flows from operating, investing, and financing activities, and classify cash flow items as relating to one of these thrce categories, givcn a description or the items.

Items on the cash flow statement come from two sources: (1) income statement items and (2) changes in balance sheet accounts. A firm's cash receipts and payments are classified on the cash flow statement as either operating, investing, or financing activities.

Study Session 8

Cross-Reference to erA Institute Assigned Reading #34 - Understanding the Cash Flow Statement

Cash flow from operating activities (CrO), sometimes referred ro as "cash How from operations" or "operating cash How," consists of the inflows and outflows of cash resulting from transactions that affeer a 11rm's ncr income.

Cash How from investing activities ((TI) consists of the inHows and ourllows of cash resulting (rom the acquisition or disposal of long-tt:fl11 assets and certain investments.

Cash How from f1nancing activities (CFF) consisls of the iniJows and oudJows of cash resulting from transactions affecring a firm's capital structure.

Examples of each cash How classif1cation, in accordance with U.S. CAAP, arc presel1lcd in Figure 1.

Fignrc 1: U.S. GAAP Cash Flow Classifications

Operating Activities

Note that the acquisition of debt and equity investments (other than trading securities) and loans made to others are reponed as investing activities; however, the income from these investments (interest and dividends received) is reported as an operating activity.

Also, note that principal amounts borrowed from others are reponed as financing acrivities; however, the interest paid is reponed as an operating activity. Finally, note that dividends paid to rhe firm's shareholders arc financing activities.

Professor's Note: Don't ronfuse dividends rereived and dividends paid. Under u.s. GAAP, dividends received are operating activities and dividends paid are financing activities.