C H A P T E R The Balance Sheet Old accountants never die; they just lose their balance. 2 —ANONYMOUS A balance sheet, also called the statement of condition or statement of financial position, provides a wealth of valuable information about a business firm, particularly when examined over a period of several years and evaluated in relation to the other financial statements. A prerequisite to learning what the balance sheet can teach us, however, is a fundamental understanding of the accounts in the statement and the relationship of each account to the financial statements as a whole.

Consider, for example, the balance sheet inventory account. Inventory is an important component of liquidity analysis, which considers the ability of a firm to meet cash needs as they arise. (Liquidity analysis will be discussed in Chapter 6. ) Any measure of liquidity that includes inventory as a component would be meaningless without a general understanding of how the balance sheet inventory amount is derived.

This chapter will thus cover such issues as what inventories are, how the inventory balance is affected by accounting policies, why companies choose and sometimes change methods of inventory valuation, where to find disclosures regarding inventory accounting, and how this one account contributes to the overall measurement of a company’s financial condition and operating performance. This step-by-step descriptive treatment of inventories and other balance sheet accounts will provide the background necessary to analyze and interpret balance sheet information. Financial Condition

The balance sheet shows the financial condition or financial position of a company on a particular date. The statement is a summary of what the firm owns (assets) and what the firm owes to outsiders (liabilities) and to internal owners (stockholders’ equity). By definition, the account balances on a balance sheet must balance; that is, the total of all assets must equal the sum of liabilities and stockholders’ equity. The balancing equation is expressed as: Assets Liabilities Stockholders’ equity ISBN: 0-536-48044-3 44 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall.

Copyright © 2007 by Pearson Education, Inc. CHAPTER 2 The Balance Sheet 45 This chapter will cover account by account the consolidated balance sheet of Recreational Equipment and Clothing, inc. (R. E. C. Inc. ) (Exhibit 2. 1). This particular firm sells recreational products through retail outlets, some owned and some leased, in cities located throughout the southwestern United States. Although the accounts on a balance sheet will vary somewhat by firm and by industry, those described in this chapter will be common to most companies. Consolidation Note first that the statements are “consolidated” for R. E. C. Inc. and subsidiaries.

When a parent owns more than 50% of the voting stock of a subsidiary, the financial statements are combined for the companies in spite of the fact that they are separate legal entities. The statements are consolidated because the companies are in substance one company, given the proportion of control by the parent. In the case of R. E. C. Inc. , the subsidiaries are wholly owned, which means that the parent controls 100% of the voting shares of the subsidiaries. Where less than 100% ownership exists, there are accounts in the consolidated balance sheet and income statement to reflect the minority interest in net assets and income.

Balance Sheet Date The balance sheet is prepared at a point in time at the end of an accounting period, a year, or a quarter. Most companies, like R. E. C. Inc. , use the calendar year with the accounting period ending on December 31. Interim statements would be prepared for each quarter, ending March 31, June 30, and September 30. Some companies adopt a fiscal year ending on a date other than December 31. The fact that the balance sheet is prepared on a particular date is significant.

For example, cash is the first account listed on the balance sheet and represents the amount of cash on December 31; the amount could be materially different on December 30 or January 2. Comparative Data Financial statements for only one accounting period would be of limited value because there would be no reference point for determining changes in a company’s financial record over time. As part of an integrated disclosure system required by the SEC, the information presented in annual reports to shareholders includes two-year audited balance sheets and three-year audited statements of income and cash flows.

The balance sheet for R. E. C. Inc. thus shows the condition of the company at December 31, 2007 and 2006. Common-Size Balance Sheet A useful tool for analyzing the balance sheet is a common-size balance sheet. Common-size financial statements are a form of vertical ratio analysis that allows for comparison of firms with different levels of sales or total assets by introducing a common denominator. Common-size statements are also useful to evaluate trends within a firm and to make industry comparisons. The common-size balance sheet for R. E. C. Inc. is presented in Exhibit 2. 2.

Information from the common-size balance sheet will be used throughout this chapter and also in Chapter 6. A common-size balance sheet ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 46 CHAPTER 2 The Balance Sheet EXHIBIT 2. 1 R. E. C. Inc. Consolidated Balance Sheets at December 31, 2007 and 2006 (in Thousands) 2007 2006 Assets Current Assets Cash Marketable securities (Note A) Accounts receivable, less allowance for doubtful accounts of $448 in 2007 and $417 in 006 Inventories (Note A) Prepaid expenses Total current assets Property, Plant, and Equipment (Notes A, C, and E) Land Buildings and leasehold improvements Equipment Less accumulated depreciation and amortization Net property, plant, and equipment Other Assets (Note A) Total Assets Liabilities and Stockholders’ Equity Current Liabilities Accounts payable Notes payable—banks (Note B) Current maturities of long-term debt (Note C) Accrued liabilities Total current liabilities Deferred Federal Income Taxes (Notes A and D) Long-Term Debt (Note C) Commitments (Note E) Total liabilities Stockholder’s Equity Common stock, par value $1, authorized, 10,000,000 shares; issued, 4,803,000 shares in 2007 and 4,594,000 shares in 2006 (Note F) Additional paid-in capital Retained earnings Total stockholders’ equity Total Liabilities and Stockholders’ Equity The accompanying notes are an integral part of these statements. $ 4,061 5,272 8,960 47,041 512 65,846 811 18,273 21,523 40,607 11,528 29,079 373 $95,298 $ 2,382 8,004 8,350 36,769 759 56,264 811 11,928 13,768 26,507 7,530 18,977 668 $75,909 $14,294 5,614 1,884 5,669 27,461 843 21,059 $ 7,591 6,012 1,516 5,313 20,432 635 16,975 49,363 38,042 4,803 957 40,175 45,935 $95,298 4,594 910 32,363 37,867 $75,909 ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 2 The Balance Sheet 47 EXHIBIT 2. 2 R. E. C. Inc. Common-Size Balance Sheets (Percent) 2007 2006 2005 2004 2003

Assets Current Assets Cash Marketable securities Accounts receivable, less allowance for doubtful accounts Inventories Prepaid expenses Total current assets Property, Plant, and Equipment Land Buildings and leasehold improvements Equipment Less accumulated depreciation and amortization Net property, plant, and equipment Other Assets Total Assets Liabilities and Stockholders’ Equity Current Liabilities Accounts payable Notes payable—banks Current maturities of long-term debt Accrued liabilities Total current liabilities Deferred Federal Income Taxes Long-Term Debt Total liabilities Stockholders’ Equity Common stock Additional paid-in capital Retained earnings Total stockholders’ equity Total Liabilities and Stockholders’ Equity 4. 3 5. 5 9. 4 49. 4 . 5 69. 1 . 8 19. 2 22. 6 (12. 1) 30. 5 . 4 100. 0 3. 1 10. 6 11. 0 48. 4 1. 0 74. 1 1. 1 15. 7 18. 1 (9. 9) 25. 0 . 9 100. 0 3. 9 14. 9 7. 6 45. 0 1. 6 73. 0 1. 2 14. 4 17. 3 (6. 9) 26. 0 1. 0 100. 0 5. 1 15. 3 6. 40. 1 2. 4 69. 5 1. 4 14. 1 15. 9 (3. 1) 28. 3 2. 2 100. 0 4. 9 15. 1 6. 8 39. 7 2. 6 69. 1 1. 4 14. 5 16. 5 (3. 0) 29. 4 1. 5 100. 0 15. 0 5. 9 2. 0 5. 9 28. 8 . 9 22. 1 51. 8 5. 0 1. 0 42. 2 48. 2 100. 0 10. 0 7. 9 2. 0 7. 0 26. 9 . 8 22. 4 50. 1 6. 1 1. 2 42. 6 49. 9 100. 0 13. 1 6. 2 2. 4 10. 6 32. 3 . 7 16. 2 49. 2 6. 7 1. 3 42. 8 50. 8 100. 0 11. 4 4. 4 2. 4 7. 7 25. 9 . 5 14. 4 40. 8 7. 3 1. 6 50. 3 59. 2 100. 0 11. 8 4. 3 2. 6 5. 7 24. 4 . 4 14. 9 39. 7 7. 5 1. 8 51. 0 60. 3 100. 0 expresses each item on the balance sheet as a percentage of total assets. Common-size statements facilitate the internal or structural analysis of a firm.

The common-size balance sheet reveals the composition of assets within major categories, for example, cash and cash equivalents relative to other current assets, the distribution of assets in which funds are invested (current, long-lived, intangible), the capital structure of the firm (debt relative to equity), and the debt structure (long-term relative to short-term). ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 48 CHAPTER 2 The Balance Sheet Assets Current Assets Assets are segregated on a balance sheet according to how they are utilized (Exhibit 2. 3).

Current assets include cash or those assets expected to be converted into cash within one year or one operating cycle, whichever is longer. The operating cycle is the time required to purchase or manufacture inventory, sell the product, and collect the cash. For most companies, the operating cycle is less than one year, but in some industries—such as tobacco and wine—it is longer. The designation “current” refers essentially to those assets that are continually used up and replenished in the ongoing operations of the business. The term working capital or net working capital is used to designate the amount by which current assets exceed current liabilities (current assets less current liabilities).

Cash and Marketable Securities These two accounts, shown separately for R. E. C. Inc. in Exhibit 2. 3, are often combined as “cash and cash equivalents. ” The cash account is exactly that, cash in any form—cash awaiting deposit or in a bank account. Marketable securities (also referred to as short-term investments) are cash substitutes, cash that is not needed immediately in the business and is temporarily invested to earn a return. These investments are in instruments with short-term maturities (less than one year) to minimize the risk of interest rate fluctuations. They must be relatively riskless securities and highly liquid so EXHIBIT 2. 3 R. E. C. Inc.

Consolidated Balance Sheets at December 31, 2007 and 2006 (in Thousands) 2007 2006 Assets Current Assets Cash Marketable securities (Note A) Accounts receivable, less allowance for doubtful accounts of $448 in 2007 and $417 in 2006 Inventories (Note A) Prepaid expenses Total current assets Property, Plant, and Equipment (Notes A, C, and E) Land Buildings and leasehold improvements Equipment Less accumulated depreciation and amortization Net property, plant, and equipment Other Assets (Note A) Total Assets $ 4,061 5,272 8,960 47,041 512 65,846 $ 2,382 8,004 8,350 36,769 759 56,264 811 18,273 21,523 40,607 11,528 29,079 373 $95,298 811 11,928 13,768 26,507 7,530 18,977 668 $75,909 ISBN: 0-536-48044-3

Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 2 The Balance Sheet 49 that funds can be readily withdrawn as needed. Instruments used for such purposes include U. S. Treasury bills, certificates, notes, and bonds; negotiable certificates of deposit at financial institutions; and commercial paper (unsecured promissory notes of large business firms). As can be seen on the common-size balance sheet, there has been a change in the amount of cash and marketable securities held by R. E. C. Inc. from 20% in 2003 to less than 10% in 2007.

This has resulted in increases to other asset accounts. Under an accounting rule issued in 1993, the valuation of marketable securities on the balance sheet as well as other investments in debt and equity securities depends on the intent of the investment. Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,”1 effective for fiscal years beginning after December 15, 1993, requires the separation of investment securities into three categories: 1. Held to maturity applies to those debt securities that the firm has the positive intent and ability to hold to maturity; these securities are reported at amortized cost. 2.

Trading securities are debt and equity securities that are held for resale in the short term, as opposed to being held to realize longer-term gains from capital appreciation. These securities are reported at fair value with unrealized gains and losses included in earnings. 3. Securities available for sale are debt and equity securities that are not classified as one of the other two categories, either held to maturity or trading securities. Securities available for sale are reported at fair value with unrealized gains and losses included in comprehensive income. The cumulative net unrealized gains or losses are reported in the accumulated other comprehensive income section of stockholders’ equity. Financial Accounting Standards Board (FASB) Statement No. 15 does not apply to investments in consolidated subsidiaries nor to investments in equity securities accounted for under the equity method (discussed in Chapter 3). This accounting requirement most significantly affects financial institutions and insurance companies, which trade heavily in securities as part of their operating activities. The kinds of securities held by companies such as R. E. C. Inc. under the category “marketable securities” or “cash equivalents” are selected for ready conversion into cash, and they have market values that are equal to or very close to cost, as reported in Note A (see Exhibit 1. 2) to the R. E. C. Inc. financial statements. “Marketable securities consist of short-term, interest-bearing securities stated at cost, which approximates 1 Some terms that may be helpful to the reader are the following: Debt securities are securities representing a creditor relationship, including U. S. Treasury securities, municipal securities, corporate bonds, convertible debt, and commercial paper. Equity securities represent an ownership interest in an entity, including common and preferred stock. Fair value is the amount at which a financial instrument could be exchanged in a current transaction between willing parties; if a quoted market price is available, the fair value is the number of trading units multiplied by the market price.

Amortized cost refers to the fact that bonds (a debt security) may sell at a premium or discount because the stated rate of interest on the bonds is different from the market rate of interest; the premium or discount is “amortized” over the life of the bonds so that at maturity the cost equals the face amount. For more reading about FASB Statement No. 115, see J. T. Parks, “FASB 115: It’s Back to the Future for Market Value Accounting,” Journal of Accountancy, September 1993. ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 50 CHAPTER 2 The Balance Sheet market. ”) Should values be different from cost, however, then the company would have to determine which category of investment applies.

For example, if these kinds of securities were considered to be “available for sale,” they would be marked to current value, and cumulative unrealized gains and losses would be carried as a component of stockholders’ equity in the balance sheet. Accounts Receivable Accounts receivable are customer balances outstanding on credit sales and are reported on the balance sheet at their net realizable value, that is, the actual amount of the account less an allowance for doubtful accounts. Management must estimate— based on such factors as past experience, knowledge of customer quality, the state of the economy, the firm’s collection policies—the dollar amount of accounts they expect will be uncollectible during an accounting period. Actual losses are written off against the allowance account, which is adjusted at the end of each accounting period.

The allowance for doubtful accounts can be important in assessing earnings quality. If, for instance, a company expands sales by lowering its credit standards, there should be a corresponding percentage increase in the allowance account. The estimation of this account will affect both the valuation of accounts receivable on the balance sheet and the recognition of bad debt expense on the income statement. The analyst should be alert to changes in the allowance account—both relative to the level of sales and the amount of accounts receivable outstanding—and to the justification for any variations from past practices. The allowance account for R. E. C. Inc. represents approximately 5% of total customer accounts receivable.

To obtain the exact percentage figure, the amount of the allowance account must be added to the net accounts receivable balance shown on the face of the statement: 2007 448 8,960 448 2006 417 4. 8% 4. 8% 8,350 417 Allowance for doubtful accounts Accounts receivable (net) Allowance The allowance account, which is deducted from the balance sheet accounts receivable account, should reflect the volume of credit sales, the firm’s past experience with customers, the customer base, the firm’s credit policies, the firm’s collection practices, economic conditions, and changes in any of these. There should be a consistent relationship between the rate of change or growth rates in sales, accounts receivable, and the allowance for doubtful accounts.

If the amounts are changing at significantly different rates or in different directions, for example, if sales and accounts receivable are increasing, but the allowance account is decreasing or is increasing at a much smaller rate, the analyst should be alert to the potential for manipulation using the allowance account. Of course, there could be a plausible reason for such a change. The relevant items needed to relate sales growth with accounts receivable and the allowance for doubtful accounts are found on the income statement (sales) and ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 2 The Balance Sheet 51 balance sheet (accounts receivable and allowance for doubtful accounts). The following information is from the income statement and balance sheet of R.

E. C. Inc. (In Thousands) Net sales Accounts receivable (total) Allowance for doubtful accounts 2007 $215,600 9,408 448 2006 $153,000 8,767 417 Growth Rate* (% Change) 40. 9 7. 3 7. 4 *Growth rates are calculated using the following formula: Current amount – Prior Amount Prior Amount To analyze the preceding information consider the following: • The relationship among changes in sales, accounts receivable, and the allowance for doubtful accounts—are all three accounts changing in the same directions and at consistent rates of change? • If the direction and rates of change are not consistent, what are possible explanations for these differences? If there is not a normal relationship between the growth rates, what are possible reasons for the abnormal pattern? For R. E. C. Inc. , sales, accounts receivable, and the allowance for doubtful accounts have all increased, but sales have grown at a much greater rate. The percentage increase in accounts receivable and the allowance account seems lower than expected relative to the change in sales. This relationship is probably a positive one for R. E. C. because it means that the company has collected more sales in cash and thus will have potentially fewer defaults. The allowance account has increased appropriately in relation to accounts receivable, 7. 4% and 7. % respectively; the allowance account, relative to accounts receivable, is constant at 4. 8% in both years. Had the allowance account decreased there would be concern that management may be manipulating the numbers in order to increase the earnings number. Additional information helpful to the analysis of accounts receivable and the allowance account is provided in the schedule of “Valuation and Qualifying Accounts” required by the SEC in the Form 10-K. Companies sometimes include this schedule in the notes to the financial statements, but usually it is found under Item 15 of the Form 10-K. R. E. C. Inc. ’s schedule from the Form 10-K is shown here: R. E. C. Inc.

Schedule II—Valuation and Qualifying Accounts December 31, 2007, 2006, and 2005 (in Thousands) Balance at Beginning of Year Allowance for doubtful accounts 2007 2006 2005 ISBN: 0-536-48044-3 Additions Charged to Costs and Expenses Deductions Balance at End of Year $417 $400 $391 $271 $217 $259 $240 $200 $250 $448 $417 $400 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 52 CHAPTER 2 The Balance Sheet The column labeled “Additions Charged to Costs and Expenses” is the amount R. E. C. Inc. has estimated and recorded as bad debt expense each year on the income statement.

The “Deductions” column represents the actual amount that the firm has written off as accounts receivable they no longer expect to recover from customers. Since the expense is estimated each year this amount also includes corrections of prior years’ over- or under-estimations. The analyst should use this schedule to assess the probability that the firm is intentionally over- or under-estimating the allowance account in order to manipulate the net earnings number on the income statement. R. E. C. Inc. appears to estimate an expense fairly close to the actual amount written off each year, although the firm has estimated slightly more expense than has actually been incurred. Further analysis of accounts receivable and its quality is covered in Chapters 5 and 6.

Inventories Inventories are items held for sale or used in the manufacture of products that will be sold. A retail company, such as R. E. C. Inc. , lists only one type of inventory on the balance sheet: merchandise inventories purchased for resale to the public. A manufacturing firm, in contrast, would carry three different types of inventories: raw materials or supplies, workin-process, and finished goods. For most firms, inventories are the firm’s major revenue producer. Exceptions would be service-oriented companies that carry little or no inventory. Exhibit 2. 4 illustrates the proportion of inventories at the manufacturing, wholesale, and retail levels.

For these industries—drugs, household furniture, and sporting goods—the percentage of inventories to total assets ranges from 21. 2% to 38. 8% at the manufacturing stage to 37. 4% to 60. 0% for retail firms. The common-size balance sheet (Exhibit 2. 2) for R. E. C. Inc. reveals that inventories comprise 49. 4% and 48. 4% of total assets, respectively, in 2007 and 2006. As mentioned previously, from 2003 to 2007, cash and marketable securities have decreased by approximately 10%. Inventories have increased by almost 10% in this same time frame, indicating a shift in asset structure. Most likely, R. E. C. Inc. has chosen to spend cash to expand.

As new stores are opened, they must be stocked with inventory. EXHIBIT 2. 4 Inventories as a Percentage of Total Assets Manufacturing Pharmaceutical preparations Household furniture Sporting and athletic goods Wholesale Drugs Furniture Sporting and recreational goods Retail Drug stores Furniture stores Sporting goods stores % 21. 2 37. 4 38. 8 32. 5 30. 2 44. 4 37. 4 50. 4 60. 0 Source: The Risk Management Association, Annual Statement Studies, Philadelphia, PA, 2004. ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 2

The Balance Sheet 53 Given the relative magnitude of inventory, the accounting method chosen to value inventory and the associated measurement of cost of goods sold have a considerable impact on a company’s financial position and operating results. Understanding the fundamentals of inventory accounting and the effect various methods have on a company’s financial statements is essential to the user of financial statement information. Inventory Accounting Methods The method chosen by a company to account for inventory determines the value of inventory on the balance sheet and the amount of expense recognized for cost of goods sold on the income statement.

The significance of inventory accounting is underlined by the presence of inflation and by the implications for tax payments and cash flow. Inventory valuation is based on an assumption regarding the flow of goods and has nothing whatever to do with the actual order in which products are sold. The cost flow assumption is made in order to match the cost of products sold during an accounting period to the revenue generated from the sales and to assign a dollar value to the inventory remaining for sale at the end of the accounting period. The three cost flow assumptions most frequently used by U. S. companies are FIFO (first in, first out), LIFO (last in, first out), and average cost.

As the terms imply, the FIFO method assumes the first units purchased are the first units sold during an accounting period; LIFO assumes that the items bought last are sold first; and the average cost method uses an average purchase price to determine the cost of products sold. A simple example should highlight the differences in the three methods. A new company in its first year of operations purchases five products for sale in the order and at the prices shown: Item #1 #2 #3 #4 #5 Purchase Price $ 5 $ 7 $ 8 $ 9 $11 The company sells three of these items, all at the end of the year. The cost flow assumptions would be: Accounting Method FIFO LIFO Average cost Goods Sold #1, #2, #3 #5, #4, #3 [Total cost/5] ? Goods Remaining in Inventory #4, #5 #2, #1 [Total cost/5] ? 2 The resulting effect on the income statement and balance sheet would be: Accounting Method FIFO LIFO Average cost Cost of Goods Sold (Income Statement) $20 $28 $24 Inventory Valuation (Balance Sheet) $20 $12 $16 ISBN: 0-536-48044-3 It can be clearly seen that during a period of inflation, with product prices increasing, the LIFO method produces the highest cost of goods sold expense ($28) and the lowest Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 54 CHAPTER 2 The Balance Sheet ending valuation of inventory ($12).

Further, cost of goods sold under the LIFO method most closely approximates the current cost of inventory items since they are the most recent purchases. On the other hand, inventories on the balance sheet are undervalued with respect to replacement cost because they reflect the older costs when prices were lower. If a firm uses LIFO to value inventory, no restatement is required to adjust cost of goods sold for inflation because LIFO matches current costs to current sales. Inventory on the balance sheet, however, would have to be revalued upward to account for inflation. FIFO has the opposite effect; during a period of rising prices, balance sheet inventory is valued at current cost, but cost of goods sold on the income statement is understated.

In an annual survey of accounting practices followed by 600 industrial and merchandising corporations in the United States in the early 1970s, 146 companies surveyed reported using LIFO to account for all or part of inventory. By the 1990s, this number had increased to 326 but then fell to 251 by 2003. 2 Why did so many companies switch to LIFO in the 1990s? The answer is taxes. Referring back to the example, note that when prices are rising (inflation), LIFO produces the largest cost of goods sold expense. The greater the expense deduction, the lower is taxable income. Use of LIFO thus reduces a company’s tax bill during inflation. Unlike the case for some accounting rules—where a firm is allowed to use one method for tax and another method for reporting purposes—a company that elects LIFO to figure taxable income must also use LIFO for reported income.

The many companies that have switched to LIFO from other methods are apparently willing to trade lower reported earnings for the positive cash benefits resulting from LIFO’s beneficial tax effect. The evidence, however, is that the trend toward LIFO is reversing and that the number of firms electing FIFO is gradually increasing. Reasons could include both a lower inflation rate and the desire to report higher accounting earnings. In the earlier example, LIFO produced lower earnings than FIFO or average cost, but there can be exceptions. Obviously, in a period of falling prices (deflation) the results would reverse. Also, some firms experience price movements that are counter to the general trend—the high-technology industry, where prices on many products have declined, is a case in point. 3

Because the inventory cost flow assumption has a significant impact on financial statements—the amount of inventory reported on the balance sheet and the cost of goods sold expense in the income statement—it is important to know where to find its disclosure (see Figure 2. 1). The method used to value inventory will generally be shown in the note to the financial statements relating to inventory. R. E. C. Inc. has the following explanation in Note A: Inventories are carried at the lower of cost (LIFO) or market. This statement indicates that the LIFO method is used to determine cost. The fact that inventories are valued at the lower of cost or market reflects the accounting convention of conservatism. If the actual market value of inventory falls below cost, as determined by the cost flow assumption (LIFO for R. E. C. Inc. ), then inventory will be 3 Accounting Trends and Techniques, American Institute of Certified Public Accountants, 1971, 1998, 2004. Another exception that causes higher earnings when using LIFO during inflationary periods is a base LIFO layer liquidation. This occurs when a firm sells more goods than purchased or manufactured during an accounting period, resulting in the least expensive items being charged to cost of goods sold. To avoid the LIFO liquidation problem, some firms use the dollar-value LIFO method, which is applied to goods in designated pools and measures inventory changes in cost dollars—using a price index—rather than physical units. ISBN: 0-536-48044-3

Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 2 The Balance Sheet 55 FIGURE 2. 1 Inventory Methods Accounting Method FIFO Cost of Goods Sold (Income Statement) First purchases Inventory Valuation (Balance Sheet) Last purchases (close to current cost) First purchases LIFO Last purchases (close to current cost) Average of all purchases Average Cost Average of all purchases written down to market price. Notice that the phrase is “lower” of cost or market. The carrying value of inventory would never be written up to market value—only down. The inventory note for R. E. C. Inc. lso provides information regarding the value of inventory had FIFO been used, since the FIFO valuation would be higher than that recorded on the balance sheet and more closely approximates current value: “If the first in, first out (FIFO) method of inventory accounting had been used, inventories would have been approximately $2,681,000 and $2,096,000 higher than reported at December 31, 2007 and 2006. ” Prepaid Expenses Certain expenses, such as insurance, rent, property taxes, and utilities, are sometimes paid in advance. They are included in current assets if they will expire within one year or one operating cycle, whichever is longer. Generally, prepayments are not material to the balance sheet as a whole. For R. E. C. Inc. , prepaid expenses represent less than 1% of total current assets in 2007.

Property, Plant, and Equipment This category encompasses a company’s fixed assets (also called tangible, long-lived, and capital assets)—those assets not used up in the ebb and flow of annual business operations. These assets produce economic benefits for more than one year, and they are considered “tangible” because they have a physical substance. Fixed assets other than land (which has a theoretically unlimited life span) are “depreciated” over the period of time they benefit the firm. The process of depreciation is a method of allocating the cost of long-lived assets. The original cost, less any estimated residual value at the end of the asset’s life, is spread over the expected life of the asset. Cost is also considered to encompass any expenditures made to ready the asset for operating use.

On any balance sheet date, property, plant, and equipment is shown at book value, which is the difference between original cost and any accumulated depreciation to date. Management has considerable discretion with respect to fixed assets, as was explained in Chapter 1. Depreciation involves estimates of the economic life of the asset and any salvage value expected to be recoverable at the end of this life. Further, the ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 56 CHAPTER 2 The Balance Sheet amount of depreciation expense recognized each period is determined by the depreciation method chosen.

Although the total amount of depreciation over the asset’s life is the same regardless of method, the rate of depreciation varies. The straight-line method spreads the expense evenly by periods, and the accelerated methods yield higher depreciation expense in the early years of an asset’s useful life, and lower depreciation expense in the later years. Another depreciation choice is the units-of-production method, which bases depreciation expense for a given period on actual use. According to Accounting Trends and Techniques, the vast majority of companies use the straightline method for financial reporting:4 Straight line Accelerated Units of production 580 68 30 Refer now to the property, plant, and equipment section of the R. E. C. Inc. balance sheet.

First note that there are three categories listed separately: land, buildings and leasehold improvements, and equipment. Land, as designated in the fixed asset section, refers to property used in the business; this would be land on which there are corporate offices and retail stores. Any land held for investment purposes would be segregated from property used in the business. (For R. E. C. Inc. , see the “Other Assets” section. ) R. E. C. Inc. owns some of its retail outlets, and others are leased. Buildings would include those stores owned by the company as well as its corporate offices. Leasehold improvements are additions or improvements made to leased structures.

Because leasehold improvements revert to the property owner when the lease term expires, they are amortized by the lessee over the economic life of the improvement or the life of the lease, whichever is shorter. 5 Some companies may also have an account called construction in progress. These are the costs of constructing new buildings that are not yet complete. R. E. C. Inc. does not include this account on their balance sheet. Equipment represents the original cost, including delivery and installation charges, of the machinery and equipment used in business operations. Included are a variety of items such as the centralized computer system; equipment and furnishings for offices, stores, and warehouses; and delivery trucks.

The final two lines under the property, plant, and equipment section for R. E. C. Inc. show the amount of accumulated depreciation and amortization (for all items except land) and the amount of net property, plant, and equipment after the deduction of accumulated depreciation and amortization. The relative proportion of fixed assets in a company’s asset structure will largely be determined by the nature of the business. A firm that manufactures products would likely be more heavily invested in capital equipment than a retailer or wholesaler. Exhibit 2. 5 shows the relative percentage of net fixed assets to total assets for the same three industries identified in Exhibit 2. 4.

Realize, however, that firms with newly purchased fixed assets will have a higher percentage than firms with older, and hence, lower net fixed asset numbers. 4 Accounting Trends 5 and Techniques, American Institute of Certified Public Accountants, 2004. Amortization is the term used to designate the cost allocation process for assets other than buildings, machinery, and equipment—such as leasehold improvements and intangible assets, discussed later in the chapter. ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 2 The Balance Sheet 57 EXHIBIT 2. 5

Net Fixed Assets as a Percent of Total Assets Manufacturing Pharmaceutical preparations Household furniture Sporting and athletic goods Wholesale Drugs Furniture Sporting and recreational goods Retail Drug stores Furniture stores Sporting goods stores Source: The Risk Management Association, Annual Statement Studies, Philadelphia, PA, 2004. % 22. 8 20. 5 15. 5 10. 6 13. 1 10. 5 13. 8 18. 4 15. 8 Fixed assets are most prominent at the manufacturing level; retailers are next, probably because retailers require stores and buildings in which to sell products; and the wholesale segment requires the least investment in fixed assets. For R. E. C. Inc. , net fixed assets have increased in proportion to total assets between 2006 and 2007 from 25. 0% to 30. 5% as can be seen on the common-size balance sheet (Exhibit 2. 2). Chapter 6 covers the financial ratios used to measure the efficiency of managing these assets.

Other Assets Other assets on a firm’s balance sheet can include a multitude of other noncurrent items such as property held for sale, start-up costs in connection with a new business, the cash surrender value of life insurance policies, and long-term advance payments. For R. E. C. Inc. , other assets represent minor holdings of property not used in business operations (as explained in Note A to the financial statements). Additional categories of noncurrent assets frequently encountered (but not present for R. E. C. Inc. ) are long-term investments6 and intangible assets, such as goodwill recognized in business combinations, patents, trademarks, copyrights, brand names, and franchises.

Of the intangible assets, goodwill is the most important for analytical purposes because of its potential materiality on the balance sheet of firms heavily involved in acquisitions activity. Goodwill arises when one company acquires another company (in a business combination accounted for as a purchase) for a price in excess of the fair market value of the net identifiable assets (identifiable assets less liabilities assumed) acquired. 6 Reporting requirements for investments in debt and equity securities must follow the provisions of FASB Statement No. 115, presented earlier in the chapter. A more extensive discussion of investments in unconsolidated subsidiaries is provided in Chapter 3. As noted earlier in the chapter, FASB Statement No. 15 does not apply to investments in consolidated subsidiaries nor to investments in equity securities accounted for by the equity method. ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 58 CHAPTER 2 The Balance Sheet This excess price is recorded on the books of the acquiring company as goodwill. Prior to the issuance of FASB Statement No. 142, “Goodwill and Other Intangible Assets,” there were two methods of accounting for acquisitions: pooling (financial statements combined and no goodwill recognized) and purchase (creation of goodwill for amount in excess of net identifiable assets).

As of January 1, 2002, the FASB eliminated the pooling method entirely, and goodwill under the purchase method will no longer be amortized. Beginning in 2002, companies evaluated goodwill and determined whether it had lost value. If it had, the amount of impairment was expensed in the year the determination was made. No write-up is recorded for gains. What that means is that some corporations will take enormous write-offs when companies they have acquired have lost value. As implementation of this new rule takes place, earnings may increase for some firms relative to prior years because amortization expense will no longer be recorded—the increased earnings reflect a “paper” increase due to the FASB rule change.

Companies will also have some discretion in deciding when and how much write-off to take as a result of goodwill impairment. In a study of the 1,000 largest U. S. companies conducted by BusinessWeek and Standard & Poor’s in 2001, it was estimated that dozens of companies would have multimillion-dollar goodwill write-offs. 7 Qwest, for example, announced that its 2002 write-off would be $30 to $40 billion, arising largely from the acquisition of U. S. West. On the plus side, firms will not have to deduct amortization expense each year, which will increase earnings for many companies. Kodak estimated that in 2002, the year the rule becomes effective, not having to deduct amortization expense will boost earnings by 45 cents per share. Liabilities

Current Liabilities Liabilities represent claims against assets, and current liabilities are those that must be satisfied in one year or one operating cycle, whichever is longer. Current liabilities include accounts and notes payable, the current portion of long-term debt, accrued liabilities, unearned revenue, and deferred taxes. Accounts Payable Accounts payable are short-term obligations that arise from credit extended by suppliers for the purchase of goods and services. For example, when R. E. C. Inc. buys inventory on credit from a wholesaler for eventual sale to its own customers, the transaction creates an account payable. This account is eliminated when the bill is satisfied.

The ongoing process of operating a business results in the spontaneous generation of accounts payable, which increase and decrease depending on the credit policies available to the firm from its suppliers, economic conditions, and the cyclical nature of the firm’s own business operations. Note that R. E. C. Inc. has almost doubled the amount of accounts payable between 2006 and 2007 (Exhibit 2. 6). Part of the balance sheet analysis should include an exploration of 7 Peter Elstrom, David Henry, David Welsh, and Stephanie Anderson, “Today, Nortel. Tomorrow . . . ,” BusinessWeek, July 2, 2001, pp. 32–35. ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 2 The Balance Sheet 59 EXHIBIT 2. 6 R. E. C. Inc. Consolidated Balance Sheets at December 31, 2007 and 2006 (in Thousands) 2007 2006

Liabilities and Stockholders’ Equity Current Liabilities Accounts payable Notes payable—banks (Note B) Current maturities of long-term debt (Note C) Accrued liabilities Total current liabilities Deferred Federal Income Taxes (Notes A and D) Long-term debt (Note C) Commitments (Note E) Total liabilities Stockholders’ Equity Common stock, par value $1, authorized, 10,000,000 shares; issued, 4,803,000 shares in 2007 and 4,594,000 shares in 2006 (Note F) Additional paid-in capital Retained earnings Total stockholders’ equity Total Liabilities and Stockholders’ Equity The accompanying notes are an integral part of these statements. $14,294 5,614 1,884 5,669 27,461 843 21,059 $ 7,591 6,012 1,516 5,313 20,432 635 16,975 49,363 38,042 4,803 957 40,175 45,935 $95,298 4,594 910 32,363 37,867 $75,909 the causes for this increase.

To jump briefly ahead, the reader might also note that the income statement reveals a significant sales increase in 2007. Perhaps the increase in accounts payable is at least partially explained by this sales growth. Notes Payable Notes payable are short-term obligations in the form of promissory notes to suppliers or financial institutions. For R. E. C. Inc. these notes (explained in Note B to the financial statements) are payable to a bank and reflect the amount extended under a line of credit. A line of credit permits borrowing from a financial institution up to a maximum amount. The total amount that can be borrowed under R. E. C. Inc. ’s line of credit is $10 million, of which about half ($5,614,000) was outstanding debt at the end of 2007.

Current Maturities of Long-Term Debt When a firm has bonds, mortgages, or other forms of long-term debt outstanding, the portion of the principal that will be repaid during the upcoming year is classified as a current liability. The currently maturing debt for R. E. C. Inc. occurs as the result of several long-term obligations, described in Note C to the financial statements. The note ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 60 CHAPTER 2 The Balance Sheet lists the amount of long-term debt outstanding, less the portion due currently, and also provides the schedule of current maturities for the next five years. Accrued Liabilities Like most large corporations, R. E. C. Inc. ses the accrual rather than the cash basis of accounting: Revenue is recognized when it is earned, and expenses are recorded when they are incurred, regardless of when the cash is received or paid. Accrued liabilities result from the recognition of an expense in the accounting records prior to the actual payment of cash. Thus, they are liabilities because there will be an eventual cash outflow to satisfy the obligations. Assume that a company has a $100,000 note outstanding, with 12% annual interest due in semiannual installments on March 31 and September 30. For a balance sheet prepared on December 31, interest will be accrued for three months (October, November, and December): $100,000 . 2 $12,000/12 $1,000 3 $12,000 annual interest $1,000 monthly interest $3,000 accrued interest for three months The December 31 balance sheet would include an accrued liability of $3,000. Accruals also arise from salaries, rent, insurance, taxes, and other expenses. Reserve accounts are often set up for the purpose of estimating obligations for items such as warranty costs, sales returns, or restructuring charges, and are recorded as accrued liabilities. Generally, the only way to determine if a company has set up a reserve account is to read the notes to the financial statements carefully. Prior to 2003, many firms appeared to be abusing the use of reserve accounts for restructuring charges.

By overestimating the reserve and recording all potential restructuring costs in the period when the decision to restructure was made, companies could later reverse the charge, thus giving a boost to the net earnings number. The SEC’s concern regarding this possible abuse resulted in the FASB requiring firms to implement Statement of Financial Accounting Standard No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” effective January 1, 2003. This standard prohibits companies from recognizing a liability for a cost associated with an exit or disposal activity unless and until a liability has actually been incurred. Reserve accounts are also set up to record declines in asset values and the allowance for doubtful accounts explained earlier in the chapter is an example.

Unearned Revenue or Deferred Credits Companies that are paid in advance for services or products record a liability upon the receipt of cash. The liability account is referred to as unearned revenue or deferred credits. The amounts in this account will be transferred to a revenue account when the service is performed or the product delivered as required by the matching concept of accounting. R. E. C. Inc. does not have unearned revenue because it is a retail company that does not generally receive payment in advance of selling its products. However, companies in high-technology, publishing, or manufacturing industries are apt to have unearned revenue accounts on their balance sheets.

For example, Intel Corporation ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 2 The Balance Sheet 61 shows $592 million on its 2004 balance sheet for “Deferred income on shipments to distributors. ” In the footnotes to the financial statements, this account is explained as follows under the heading “Revenue recognition”: “The company recognizes net revenues when the earnings process is complete, as evidenced by an agreement with the customer, transfer of title and acceptance if applicable, as well as fixed pricing and probable collectibility.

Because of frequent sales price reductions and rapid technology obsolescence in the industry, sales made to distributors under agreements allowing price protection and/or right of return are deferred until the distributors sell the merchandise. ”8 Deferred Federal Income Taxes Deferred taxes are the result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income. The accounting principles for recording and reporting deferred taxes are specified in Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes,” which superseded Statement of Financial Accounting Standards No. 96 and is effective for fiscal years beginning after December 15, 1992.

Most large companies use one set of rules for calculating income tax expense, paid to the IRS, and another set for figuring income reported in the financial statements. The objective is to take advantage of all available tax deferrals in order to reduce actual tax payments, while showing the highest possible amount of reported net income. There are many areas in which firms are permitted to use different procedures for tax and reporting purposes. One such example, based on depreciation methods, was discussed in Chapter 1. Most firms use an accelerated method (the Modified Accelerated Cost Recovery System) to figure taxable income and the straight-line method for reporting purposes. The effect is to recognize more depreciation expense in the early years of an asset’s useful life for tax calculations.

Although depreciation methods are the most common source, other temporary differences arise from the methods used to account for installment sales, long-term contracts, leases, warranties and service contracts, pensions and other employee benefits, and subsidiary investment earnings. They are called temporary differences (or timing differences) because, in theory, the total amount of expense and revenue recognized will eventually be the same for tax and reporting purposes. There are also permanent differences in income tax accounting. Municipal bond revenue, for example, is recognized as income for reporting purposes but not for tax purposes; life insurance premiums on officers are recognized as expense for financial reporting purposes but are not deductible for income tax purposes.

These permanent differences do not affect deferred taxes because a tax will never be paid on the income or the expense will never be deducted on the tax return. The deferred tax account reconciles the temporary differences in expense and revenue recognition for any accounting period. Under FASB Statement No. 109,9 business firms recognize deferred tax liabilities for all temporary differences when the item causes financial income to exceed taxable income with an expectation that the 8 9 Intel, 2004 Annual Report, p. 54. For more reading about FASB Statement No. 109, its application and implementation, see W. J. Read and A. J. Bartsch, “Accounting for Deferred Taxes Under FASB 109”; and G. J. Gregory, T. R. Petree, and R. J.

Vitray, “FASB 109: Planning for Implementation and Beyond,” Journal of Accountancy, December 1992. ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 62 CHAPTER 2 The Balance Sheet difference will be offset in future accounting periods. Deferred tax assets are reported for deductible temporary differences and operating loss and tax credit carryforwards. A deductible temporary difference is one that causes taxable income to exceed financial income, with the expectation that the difference will be offset in the future.

Measurement of tax liabilities and assets is based on provisions of the enacted tax law; effects of future anticipated changes in tax law are not considered. A valuation allowance is used to reduce deferred tax assets to expected realizable amounts when it is determined that it is more likely than not that some of the deferred tax assets will not be realized. To illustrate the accounting for deferred taxes, assume that a company has a total annual revenue of $500,000; expenses other than depreciation are $250,000; and depreciation expense is $100,000 for tax accounting and $50,000 for financial reporting (eventually this difference would reverse and the reported depreciation expense in later years would be greater than the tax depreciation expense).

The income for tax and reporting purposes would be computed two ways, assuming a 34% tax rate: Tax $500,000 (350,000) $150,000 (51,000) $ 99,000 Reporting $500,000 (300,000) $200,000 (68,000) $132,000 Revenue Expenses Earnings before tax Tax expense (? .34) Net income Taxes actually paid ($51,000) are less than the tax expense ($68,000) reported in the financial statements. To reconcile the $17,000 difference between the expense recorded and the cash outflow, there is a deferred tax liability of $17,000: Reported tax expense Cash paid for taxes Deferred tax liability $68,000 51,000 $17,000 For an additional example of deferred taxes, including the ultimate reversal of the temporary difference, see Figure 2. 2.

Deferred taxes are classified as current or noncurrent on the balance sheet, corresponding to the classification of related assets and liabilities underlying the temporary difference. For example, a deferred tax asset arising from accounting for 90-day warranties would be considered current. On the other hand, a temporary difference based on five-year warranties would be noncurrent; depreciation accounting would also result in a noncurrent deferred tax because of the noncurrent classification of the underlying plant and equipment account. A deferred tax asset or liability that is not related to an asset or liability for financial reporting, including deferred tax assets related to carryforwards, is classified according to anticipated reversal or benefit.

At the end of the accounting period, the firm will report one net current amount and one net noncurrent amount unless the liabilities and assets are attributable to different taxpaying components of the enterprise or to different tax jurisdictions. Thus, the deferred tax account can conceivably appear on the balance sheet as a current asset, current liability, noncurrent asset, or noncurrent liability. ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 2 The Balance Sheet 63 FIGURE 2. 2 Deferred Taxes—An Example A company purchases a piece of equipment for $30,000.

The equipment is expected to last three years and have no salvage value at the end of the three-year period. Straight-line depreciation is used for financial reporting purposes and an accelerated method is used for tax purposes. The following table shows the amounts of depreciation that would be recorded for both sets of books over the three-year life of the equipment: Year 1 2 3 Depreciation expense (Financial reporting) $10,000 $10,000 $10,000 Depreciation expense (Tax reporting) $20,000 $ 6,667 $ 3,333 Assume that revenues are $90,000 and all expenses other than depreciation are $20,000 each year, the tax rate is 30%, and depreciation is the only temporary difference that creates the deferred tax account.

Calculations to determine tax expense for reporting purposes and tax paid are below: Year 1 Revenues Expenses: Depreciation Other Earnings before taxes Tax rate Tax expense Income Statement $90,000 (10,000) (20,000) $60,000 0. 30 $18,000 Tax Return $90,000 (20,000) (20,000) $50,000 0. 30 $15,000 Taxable income The recording of taxes at the end of year 1 will involve a decrease in the cash account of $15,000, an increase in tax expense of $18,000, and an increase in the deferred tax liability account of the difference, $3,000. Year 2 Revenues Expenses: Depreciation Other Earnings before taxes Tax rate Tax expense Income Statement $90,000 (10,000) (20,000) $60,000 0. 30 $18,000 Tax Return $90,000 (6,667) (20,000) $63,333 0. 30 $19,000 Taxable income

The recording of taxes at the end of year 2 will involve a decrease in the cash account of $19,000, an increase in tax expense of $18,000, and a decrease in the deferred tax liability account of the difference, $1,000. The deferred tax liability account will now have a balance of $2,000 at the end of year 2. Year 3 Revenues Expenses: Depreciation Other Earnings before taxes Tax rate Tax expense Income Statement $90,000 (10,000) (20,000) $60,000 0. 30 $18,000 Tax Return $90,000 (3,333) (20,000) $66,667 0. 30 $20,000 Taxable income The recording of taxes at the end of year 3 will involve a decrease in the cash account of $20,000, an increase in tax expense of $18,000, and a decrease in the deferred tax liability account of the difference, $2,000.

The deferred tax liability account will now have a balance of $0 at the end of year 3, as the temporary difference has completely reversed. Notice that the total amount of income tax expense ($54,000) recorded for reporting purposes is exactly equal to the tax paid ($54,000) over the three-year period. ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 64 CHAPTER 2 The Balance Sheet R. E. C. Inc. reports deferred federal income taxes as a noncurrent liability. The temporary differences are based on depreciation methods and long-term installment sales. An illustration of the disclosures related to deferred income taxes follows. Exhibit 2. shows an excerpt from Reader’s Digest, 2004 footnote on income taxes. The seven temporary differences that have created the net deferred tax asset are listed at the top of the exhibit. Five items have resulted in deferred tax liabilities. This means that Reader’s Digest has taken greater deductions on their tax return for these items than was recorded on their income statement. The deferred tax assets indicate the company has deducted more items on the income statement compared to the deductions taken on the tax return. The overall net deferred tax asset of $55. 5 indicates that in the future, Reader’s Digest should pay $55. 5 less in taxes when these temporary differences reverse.

The main reason for the net deferred tax asset is the “Accounts receivable and other allowances”. The company has recorded expenses such as bad debt estimates, but is not allowed to deduct these expenses for tax purposes until the amounts are actually written off. The valuation allowance of $12. 2 is the amount that Reader’s Digest projects will not be realized in the future. Notice that Reader’s Digest recognizes deferred tax items in four classifications on the balance sheet: current assets, noncurrent assets, current liabilities, and noncurrent liabilities. EXHIBIT 2. 7 Income Taxes—Reader’s Digest Components of deferred tax assets and liabilities are as follows: In Millions Deferred compensation and other employee benefits

Accounts receivable and other allowances Net operating loss carryforwards Other operating items, net Tax credit carryforwards Other accrued items Other, net Gross Deferred Tax Assets Valuation allowance Total Net Assets Deferred compensation and other employee benefits Deferred promotion Depreciation and amortization Deferred agency commissions Other, net Total Net Liabilities Net Deferred Taxes 2004 $ 9. 0 42. 8 22. 2 8. 2 29. 8 15. 4 4. 3 131. 7 (12. 2) 119. 5 8. 5 12. 3 14. 5 19. 1 9. 6 64. 0 $ 55. 5 2003 $ 21. 9 42. 0 15. 2 12. 3 27. 3 15. 9 5. 0 139. 6 (6. 9) 132. 7 7. 6 20. 5 6. 0 19. 2 12. 8 66. 1 $ 66. 6 Balance sheet classifications of deferred tax assets and liabilities are as follows: Prepaid expenses and other current assets Other noncurrent assets Other current liabilities Other noncurrent liabilities Net Deferred Taxes 2004 $ 38. 7 38. 7 (5. 3) (16. 6) $ 55. 5 2003 $ 44. 4 64. 4 (14. 8) (27. 4) $ 66. 6 ISBN: 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M.

Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 2 The Balance Sheet 65 Long-Term Debt Obligations with maturities beyond one year are designated on the balance sheet as noncurrent liabilities. This category can include bonded indebtedness, long-term notes payable, mortgages, obligations under leases, pension liabilities, and long-term warranties. In Note C to the financial statements, R. E. C. Inc. specifies the nature, maturity, and interest rate of each long-term obligation. Even though long-term debt increased by over $4,000 from 2006 to 2007, notice that on the common-size balance sheet (Exhibit 2. ), the percentage of long-term debt relative to total assets has declined. This has been caused by the much larger increase in accounts payable. Capital Lease Obligations A commonly used type of leasing arrangement is a capital lease. Capital leases are, in substance, a “purchase” rather than a “lease. ” If a lease contract meets any one of four criteria—transfers ownership to the lessee, contains a bargain purchase option, has a lease term of 75% or more of the leased property’s economic life, or has minimum lease payments with a present value of 90% or more of the property’s fair value—the lease must be capitalized by the lessee according to the requirements of FASB Statement No. 13, “Accounting for Leases. Leases not meeting one of the four criteria are treated as operating leases, discussed under commitments and contingencies later in the chapter. R. E. C. Inc. uses only operating leases. Both the balance sheet and the income statement are affected by a capital lease. An asset and a liability are recorded on the lessee’s balance sheet equal to the present value of the lease payments to be made under the contract. The asset account reflects what is, in essence, the purchase of an asset; and the liability is the obligation incurred in financing the purchase. Each lease payment is apportioned partly to reduce the outstanding liability and partly to interest expense.

The asset account is amortized with amortization expense recognized on the income statement, just as a purchased asset would be depreciated. Disclosures about capital leases can be found in the notes to the financial statements, often under bot