Chapter 3 Notes-Part 1 Key - CHAPTER 3 THE BALANCE SHEET...

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CHAPTER 3THE BALANCE SHEET AND FINANCIAL DISCLOSURESPART A: THE BALANCE SHEET-Sometimes referred to as Statement of Financial Position-The objective of balance sheet is to report a company’s financial position on a particular date-It presents an organized array of assets, liabilities, and shareholders’ equity at a point in time -It is a freeze or snapshot of financial position at the end of a particular day marking the end of an accounting period.Usefulness and Limitations-Does not portray the market value of the entity as a going concern, nor its liquidation value.oMany assets, like land and buildings, are measured at their historical costs rather than their fair valuesoMany company resources including its trained employees, its experienced management team, and its reputation are not recorded as assets.oMany items are reliant on estimates rather than determinable values (receivables they will be able to collect or warranty costs they will eventually incur on products alreadysold)1
oA company’s book value (i.e. its assets minus its liabilities) will not directly measure the company’s market value (number of common stock outstanding multiplied by the price per share)e.g. In early 2011, the 30 companies constituting the Dow Jones Industrial Average had an average ratio of market value to book value of approximately 3.5. e.g. the ratio for IBM was almost 9.0. Why? -The way we account for research and development costs. These costs are expensed in the period they are incurred rather than capitalized as assets in the balance sheet.Despite these limitations, balance sheet does have a significant value.-It describes many of the resources a company has available for generating future cash flows.-In combination with income statement items, it provides useful information in assessing a firm’s future profitability e.g. ROA: return on assets (net income divided by net assets)-It classifies assets and liabilities according to common characteristicsoHelpful in determining liquidityand long term solvencyLiquidity: The period of time before an asset is converted to cash or until a liability is paid.Long-term solvency:the riskiness of a company with regard to the amount ofliabilities in its capital structure.
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Other things being equal, the risk to an investor or creditor increases asthe percentage of liabilities, relative to equity, increases.Long-term solvency also provides information about financial flexibility: the ability of a company to alter cash flows in order to take advantage of unexpected investment opportunities (the higher the percentage of a company’s liabilities to its equity, the more difficult it typically will borrow additional funds)-In summary, even though the balance sheet does not directly measure the market value of an entity, it provides valuable information that can be used to help judge the market value.ClassificationsThe balance sheet elements are:Assets:probable future economic benefits obtained or controlled by a particular entity as a result

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